Mulling Over Why Oil Prices Have More Than Doubled

We return to the matter of oil prices, the questions being: Why have they more than doubled over the last four months; and are they headed still higher in the short term?

Oil today closed above $70 a barrel for the first time in seven months. As a memory-jogger, they were at $33 just in February. But unlike the last explosion in prices -- to $147 a barrel 11 months ago -- no one seems to be ruling out a role on the part of speculation.

Indeed, as the Wall Street Journal’s Ben Casselman has noted, there appears to be a broad consensus that billions of dollars in speculative money has settled in oil, thus driving up the price. The reason is that traders and investors are buying crude, among other commodities like copper, as protection because they don’t want to hold dollars whose value has been weak and volatile.

There is much said about “fundamentals.” That is, more than 2.6 billion barrels of oil is in storage around the world – including some 130 million barrels just on ships that are trolling global waters until prices go up -- and demand shows no sign of recovering. This thinking goes that the speculators have canceled out these fundamental truths.

But, isn’t it possible that the collapse in oil prices to $32 was in itself an overshoot, and that oil is at a truer balance in the $60- to $70-a-barrel range?

That seems as rational a view as any I have heard. Yet, at Alaron Energy, Phil Flynn attributes much of the price runup to Ben Bernanke over at the Federal Reserve. Flynn, normally among the clearest communicators among observers of the market, has been resorting to economic gobbledy gook for weeks about an obscure economic practice called quantitative easing.

So that O&G readers are not forced as I was to troll the Internet and confer with colleagues about this term, we are talking simply about the Fed buying federal assets like treasury bonds. By taking the Fed’s money, the sellers of these assets now have oodles of cash burning a hole in their collective pockets, Flynn argues. And what are they doing with it? Among other things, according to Flynn, buying oil.

John Authers at the Financial Times argues – probably rightly -- that the Fed may keep its current policy in place for some time. But Flynn says that the futures market suggests that the Fed may move quicker than some expect.

Of course, the longer-term trend is clear. Oil prices seem likely to spike again sooner or later because oil companies have halted so many exploration and drilling projects that, when the global economy recovers, there is probably going to be an oil shortage. And we all know what happens in oil shortages.

Why Are Oil Prices Rising?

Many are asking the question about oil prices: Is this deja vu all over again? Didn't we just go through a several-year run-up in prices based largely not on fundamentals, but on traders bidding them up, ultimately to $147 a barrel? Only then to see them plunge to $32 a barrel?

If one puts stock in the plunge, then there appears to be air in the run-up today to a six-month-high of $60 a barrel. How much is anyone’s guess. The other day, one exceedingly smart oil analyst privately put it in the range of $5 to $10 a barrel.

Here is the case for a price bubble: Oil inventories are at a 19-year high; the U.S. alone has some 1 billion barrels sitting in storage tanks, according to Mark Williams at the Associated Press. Demand for oil is set to fall to its lowest level in five years, says the U.S. Energy Information Administration.

The opposite case goes as follow: The market is factoring in expected inflation because of global deficit spending; Chinese investment spending is reviving. Over at Alaron, Phil Flynn says these are also genuine “fundamentals.”

Regardless, there always seems to be reason offered up to trust in a price run-up. After all, markets are all about emotions, as Robert Shiller notes. Yet, there are still sober voices. In my view, the Financial Times’ Chris Flood delivers it straight: Prices are rising because of various types of trading gambles. Flood quotes Mike Wittner, a senior oil analyst at Société Générale saying the following: “Recent price strength is not based on fundamentals, but on financial flows.”

Over at the Oil Drum, Rune Likvern says up to 3 million barrels a day of oil is being bought purely for storage, including on the sea. But he predicts that such purchases – which help to prop up prices – will decline because storage is becoming harder and harder to find; when they do, Likvern says, prices will fall substantially.

It’s a fool’s game to predict oil prices. That doesn’t stop a lot of people, of course, especially the traders.

The Return of High Oil

In June, a couple of Dutch energy researchers released a fascinating, long-gestating report on high oil prices. At the time, oil was selling for about $130 a barrel, and the authors, neatly dissecting the market, argued that prices were only going to get worse. Just the next month, they did rise -- to $147 a barrel.

But, as O and G readers know, there was good reason to argue the other way at least in the short term – Ed Morse, now shifted from defunct Lehman over to LCM Commodities, asserted correctly that we were in for a considerable price correction.

So, with prices having gone strongly down, as Morse forecast, I made a phone call to the report’s lead author – Jan-Hein Jesse, whom I met last year at an OPEC meeting in Vienna – and asked whether he thinks his thesis still holds. I.E., is another price spike coming down the road?

The answer, Jesse replied, is probably yes. The ‘probably’ covers the event that we are headed into a long, deep depression, in which case all such previously composed economic analyses are off the table, and one must reassess the facts afresh.

But if in the next two or three years we come out of recession in fair economic shape, look for another steep rise in oil and gasoline prices.

Fatih Birol, chief economist at the International Energy Agency, has been arguing the same point while making the rounds last week and this week in Washington and elsewhere. He’s been explaining the IEA’s latest World Energy Outlook, which is just as bleak as Jesse’s paper. Jesse wrote the paper with Coby van der Linde.

In short, demand in China, India and elsewhere in the developing world is probably going to roar back and outstrip supply in 2011 or beyond.

That alone will push prices back up. I have a story in the new Business Week on how oil companies also are now responding to $50 oil by shelving oilfield development projects. So, as Jesse told me, “In 2010 or 2011, we will be in the same situation as [the high prices of] last year. Then we will start all over again [in an energy crisis], but it will be much more difficult.”

One interesting observation of Jesse’s is that price no longer works as a stimulant in the other direction – high prices don’t necessarily motivate oil producers to flood the market with supply, and thus tamp down the upward motion of prices. That’s because almost all the available new oilfields are controlled by national oil companies like Saudi Aramco, Russia’s Gazprom and Venezuela’s PDVSA. Unlike oil companies such as Exxon and BP, which if they can are driven to maximize profit by producing more oil when prices are high, these national companies earn what they need from the higher prices, and let the rest of the oil sit in the ground.

In order to meet rising demand starting in 2011 and beyond, Jesse wrote, these producers – the companies and countries – will have to bring twice as much newly found oil onto the market in the next 22 years than what they did in the last 22 years. Meaning they will have to find and deliver 70 million barrels a day of new supply to the market. Almost no one thinks that is possible.

Jesse’s ultimate forecast is that the West – the U.S. and Europe – are going to have to use a lot less oil in order to make way for rising demand in China, India and elsewhere. If they don’t, he says, look for geopolitical tension, and another possible deep and prolonged recession. The coming energy shortages are bound to produce “sometimes confrontational relationships” between the world’s main oil consumers and the petro-states, the authors write.

Jesse and the IEA come to the same conclusion – the current global energy model isn’t sustainable. In order to avoid “the nasty side of oil scarcity,” Jesse and his co-author write, OPEC and other petro-states need to produce more oil, and the West needs to purse efficiency and the development of alternative energy.

For Motorists, 2008 Starts Out With Bad Omen

For motorists, the good news could be if former Treasury Secretary Larry Summers is right and we're headed for a huge, deep, global recession. Otherwise, 2008 looks like another expensive year on the road.

An uptick in violence in distant Nigeria helped to send crude oil prices through the roof today. A couple of crudes meant for delivery next month are at or near triple digits -- West Texas Intermediate rose to $100 a barrel, and Brent to $99.35. (Wall Street Journal piece)

This again highlights the global shortage of the types of light crude that most refineries can process into gasoline, something that won’t change until more flexible refineries come on line in three or four years. Unless demand drops -- the Summers scenario -- we're going to continue to have the tight supplies that are keeping gasoline prices high at the pump.

Meanwhile, an article in a journal published by OPEC says the world shouldn’t expect long-term relief from the Middle East. Ayoub Kazim, executive director of Dubai Knowledge Village, a government-run education center, wrote the article in the December issue of the OPEC Review. (abstract)

Carbon fuel optimists usually point to Middle East reserves as evidence that the world needn't worry about declining production in other leading petro-states, including Russia. But Kazim says that, between 2024 and 2048, OPEC countries like Saudi Arabia, Kuwait and others will be unable to satisfy their part of global demand.

If true, Kazim’s analysis would conform with the notion of an “oil plateau,” in which various constraints on production, such as equipment, manpower and expense, put an effective ceiling on total daily supply.

I’ve spoken with a number of plateau advocates, and their arguments are rational.

Photo: gothick matt
Rights: Creative Commons

Saudis: Back from the Precipice

The Saudis are acting to keep oil from crossing the $100-a-barrel line. They are clearly apprehensive about the political hullabaloo in the U.S., Europe and even China over the steep price increase for crude oil this year.

Why are the Saudis worried? The stink over the 30% rise in crude prices since September -- not to mention increasing concern over short- and medium-term oil supplies -- could mean conservation, higher efficiency and hence less demand for OPEC's oil. And that could put a damper on the Saudis' bankroll.

Hence, according to a story in tomorrow's Wall Street Journal, OPEC -- led by the Saudis -- are in the middle of adding some 720,000 barrels a day to world exports. The story, by my former colleagues Spencer Swartz and Lananh Ngyuyen, reports that the fresh supplies appear to be headed West.

I've exchange a couple of messages this evening with Michael, who points out that according to U.S. government figures there's no supply problem right now. In my own opinion, we are in an intensely erratic time, when at one moment we are in crisis because of the supply impact of a hurricane or a war, and a little while later we are swimming in oil because of other factors.

There's no doubt that conservation would be the prudent thing; but we also don't quite need to move to the forest quite yet.

Photo: ArtBrom
Rights: Creative Commons