Basically, it’s still supply and demand

Many Factors Contribute to $100 Oil

American Association of Petroleum Geologists (AAPG)

The oil industry began 2008 watching crude oil futures climb to $100 per barrel.

The rest of the world was wondering:

How did oil prices get so high in the first place?

Just a year earlier, crude started 2007 at about $60 per barrel. Few experts even mentioned the possibility of a jump to $100 within 12 months.

And that price would have been unthinkable 10 years earlier, when a worldwide slump sent oil prices below $14 a barrel.

Public reaction to soaring oil prices has ranged from outright anger to dazed confusion.

The price at the end of 2008 is anybody’s guess.

“Clearly, there’s more than just the fundamentals at play – the Saudis and OPEC have been pointing the finger at speculators, and there’s some truth to that,” said Paul Roberts.

Roberts is a national journalist and author based in the state of Washington. He wrote the 2004 book The End of Oil: On the Edge of a Perilous New World.

He also composed an influential opinion article about oil prices that recently appeared in the Los Angeles Times, Christian Science Monitor and other U.S. newspapers.

Roberts’ opinion piece examined several factors that have influenced the rise in crude prices, including the role of speculative futures trading.

“Refiners in the U.S. have been slowly reducing the reserves they keep on the shelf,” he said. “It used to be 20 days of crude supply, but as the price of crude has tripled, that’s way too much inventory for them to hold.

“Oil traders have been able to point to that and say, ‘Oh my gosh, reserves are falling,’” he noted.

But the continued upward climb of oil prices during 2007 – and a resistance to price declines – indicate that producers have struggled to meet demand, according to Roberts.

“If it were strictly speculator-driven, some speculators would start making money by taking a short position,” essentially betting that oil prices would have to fall, Roberts said.

That hasn’t happened, and “the point is, the speculators couldn’t drive prices up that high if there wasn’t a real, fundamental tightness” in the oil markets, he observed.

Here We Go Again

Uncertainty also affects the futures market, and Roberts noted a long string of negative news on the supply side.

Production declines in many older fields, like those in the North Sea, have been quicker and steeper than expected, he said. Production rates from newly developed areas like Kazakhstan have disappointed, he added.

But “on the demand side of the equation, there’s no uncertainty. It’s just rising steadily,” he said.

The resulting imbalance, with producers straining to meet increased global demand, has led to soaring oil prices and conniptive consumers.

“The public has been through this so many times. Anyone who’s middle-aged has seen these cycles before. They might be looking at this prolonged (price) spike and saying, ‘What’s the deal?’” Roberts observed.

Without an understanding of supply-demand fundamentals, consumers don’t grasp the realities pushing oil prices up, he noted. So when the public sees higher oil industry profits, people quickly identify a culprit.

“I think they just assume, ‘It’s them oil companies,’” he said.

Beyond supply-demand and a speculative component, some other factors do influence crude prices.

“The most obvious is the sagging dollar,” Roberts wrote.

“Because oil is priced in dollars, and because the dollar has fallen nearly a third against major developed-country currencies since 2002, Americans are spending more – perhaps as much as $20 more – for a barrel of oil,” he noted.

In the past few years, oil prices have increased by a much smaller percentage when measured in euros, pounds or yen, because the dollar has sagged so badly against those currencies.

Roberts believes the United States could have introduced an “energy independence tax” to inflate oil prices and cut demand following the 9/11 attacks in the United States in 2001.

“The price has gone up as much as any tax would have increased it, but that money isn’t going into our treasury,” he said. “It’s going to the Middle East or Nigeria or Russia or Venezuela.”

Going Fast, Going Slow

In recent years, many articles discussing the oil-price outlook have quoted either Jeffrey Rubin, chief economist for Canada’s CIBC World Markets, or David Wyss, chief economist at Standard & Poor’s.

Rubin was one of the few experts who saw a quick march to $100 a barrel.

As early as 2005, he predicted the oil-futures price could pass $100 by the end of 2007, missing reality by just a few days.

He based that projection largely on increasing global demand for oil consumption combined with falling export capacity in OPEC, Russia and Mexico.

By contrast, Wyss had looked for a slower and more moderated oil price increase, with crude in the $60-$70 per barrel range in 2007. Even now, he thinks market fundamentals point to a reduced price for oil.

Wyss said most analysts believe “geopolitical conflicts are causing the current run-up and that the balance of supply and demand suggests a lower price.

“However, we have been saying that for a while, and prices keep going up,” he acknowledged.

Roberts said oil companies tend to blame high prices on exploration constraints, hoping in part to overturn drilling bans.

“They will insist that the bottlenecks are all above-ground, that it’s all financing or politics,” he said. “But in terms of effect on near-term results or oil prices, the effect is exactly the same.”

The weekly publication The Economist carried several articles reacting to increased crude prices. It noted that oil companies today face higher exploration and production costs, in addition to shortages of necessary equipment and professional personnel.

“They have also been excluded from the most promising terrain for exploration by nationalist regimes, which are increasingly reluctant to share their wealth with outsiders,” The Economist said.

“Those same regimes seem in no hurry to increase their output,” it added, “partly because they realize that their sluggishness is helping to keep prices high.”

International Factors

While many consumers still blame Big Oil for prices at the pump, the general public may now see growing international demand as a primary force.

That demand growth isn’t limited to China and India. Writing for theNew York Times in December, Clifford Krauss reported that demand within big oil-producing countries is limiting exports.

“The global oil market is still dominated by traditional consumers, particularly the United States, which uses nearly a quarter of the world’s oil.

“Perhaps surprisingly, though, some producing countries have surpassed the United States in oil consumption per person. They include Bahrain, Kuwait, Qatar and the United Arab Emirates,” Krauss wrote.

“Particularly in oil-producing countries with large populations, like Indonesia, Russia and Mexico, a rapid rise in car ownership is a big factor driving consumption increases,” he noted.

Forecasts for 2008 predict continued high crude prices, given the steady increase in worldwide oil demand and the ongoing challenges to production. Only a significant recession can cut the world’s thirst for oil, many experts believe.

“Barring a recession, I don’t see anything that’s going to change the supply-demand picture,” Roberts said.

Writing for the Financial Times in January, Ed Crooks outlined several pressures behind the oil-price rise: the OPEC production cuts introduced in 2006, disappointing non-OPEC production levels, the rapid decline of established fields and growing demand in Asia.

Crooks projects a likely softening of crude prices, however, as an economic slowdown in the United States begins to impact the rest of the world.

“China attracts the attention in terms of the oil market, because it is the biggest source of demand growth, but the consumption of China and India together is less than half that of North America,” Crooks wrote.

And it will be difficult for China to “avoid the turbulence created by the economic problems of the U.S.”

“Recession in the world’s biggest oil consumer plus a slowdown in the world’s strongest-growing oil market do not sound like a prescription for high oil price,” he observed.

Oh, Grow Up

Roberts chastised Americans for a heedless and needless over-consumption of energy resources.

U.S. consumers grumble about energy prices “as they get into their very large cars and drive very large distances to work every day. They don’t see the demand side,” he said.

Business has reacted to high prices by cutting energy use as much as possible, Roberts noted. Private consumers, on the other hand, have shown a surprising lack of response.

“The hard thing to do is to convince consumers, because consumers don’t operate like businesses,” he said. “We think we do, but we don’t. We operate more like small kids, basically.”

Should government intervene to hold down oil prices?

Probably not, Roberts thinks.

He said the world is “not even close” to an economic or energy crisis at this point.

“Some people want to flood the market with Strategic Petroleum Reserve crude oil. I think that’s stupid. We need to do things differently,” Roberts commented.

“Maybe having oil stay up around $100 a barrel over the next couple of years is the best thing to happen. We really need a strong dose of market medicine,” he said, “because that’s the only thing that induces meaningful change.”

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