November 05, 2007
Traders, Not Political or Supply Concerns, May Be Pushing Fuel Toward $100
After a week of new records for crude oil prices, the question is: How high can they go?
In the past 10 weeks, the price of crude oil has shot up $25 a barrel, closing at $95.93 in New York on Friday, near an all-time inflation-adjusted peak. Unlike earlier spikes in oil prices, which came on the heels of war in the Middle East, this latest ascent does not appear to be linked to any one conflict or to any physical shortage.
Instead, traders who treat oil like any other commodity are widely thought to be driving prices upward, bolstered by a weak dollar and money flowing out of stock markets and other investment vehicles.
So far U.S. consumers have not felt the full impact. Sluggish U.S. gasoline demand over the past two months has made it hard for oil giants to pass through higher costs; refinery profit margins, which hit records in the spring, have been squeezed. But if high crude oil prices persist, they will flow through to the gas pump. Yesterday, the Lundberg Survey reported that the average retail price of regular gasoline is up 16 cents in the past two weeks to $2.96 a gallon.
Many veteran oil analysts say this is a bubble. Oil is historically a cyclical business. Modestly higher production by the Organization of Petroleum Exporting Countries, a warm winter, slower U.S. economic growth and a flattening of demand in the United States could puncture these lofty prices.
"It just seems that the market is spasming here," said Adam Robinson, an oil analyst at Lehman Brothers. If slowly declining petroleum inventories start to build again, he said, "the radical increase we've seen to the upside can repeat on the way down." Oppenheimer & Sons analyst Fadel Gheit says oil is $30 a barrel overpriced.
But analysts also say that the past 10 weeks have demonstrated the power of traders at investment houses. Deutsche Bank oil economist Adam Sieminski, who spent six months on the bank's trading desk, said it is important not to underestimate the role of sentiment and technical factors, such as patterns of price movements and the need to hedge risks in other markets. Now, when investors hold a large number of options to buy oil at a price of $100, he says, "it's almost like magnetism. It draws prices to that level."
Traders say that they are not buying and selling on whims, however. The unusually thin cushion of excess oil production around the world and the rapid growth in consumption in China and India make this rise in prices different from earlier oil price spikes, they argue. That combination, the traders add, leaves the oil markets one incident away from an even steeper increase.
"There is no current shortage, but no one deals on today's market. They make deals based on tomorrow's market. And that's what they're worried about," said Joseph Stanislaw, an oil consultant and senior adviser to the accounting firm Deloitte & Touche.
The weekend declaration of a state of emergency in Pakistan, which has no direct effect on global oil supplies, won't calm nerves.
"It would be silly if we waited until things were not available," said a veteran energy trader at a U.S. hedge fund, who spoke on the condition of anonymity to protect his business relationships. He said traders have become convinced that military conflict between the United States and Iran is inevitable. He added, "People react to perceptions of what will happen. That's not idle speculation."
Last week, nonprofit group Securing America's Future Energy engaged in some speculation. The group invited former Cabinet members and top U.S. officials to act out how a U.S. administration might respond to an oil supply disruption. The exercise assumed that a key oil pipeline was cut by explosions in Azerbaijan, an insurgency continued in Nigeria's oil-rich Niger Delta, and cuts in oil output were made by Iran and Venezuela as a result of souring U.S. relations. In this hypothetical scenario, oil prices hit $160 a barrell.
What makes the scenario more plausible than ever is that the world is consuming 85.9 million barrels of oil a day, but there are only about 2 million barrels a day of extra production capacity, almost all of it in Saudi Arabia. Much of that excess is a low-quality crude oil that can be used only in the most modernized refineries. That leaves the oil market sensitive to threats that might have been disregarded in earlier years.
Some experts say that high prices will change the balance, creating new supplies and lower demand.
"It's hard to keep in mind that things do move in cycles and that the laws of supply and demand are unlikely to have been abolished," said Daniel Yergin, chairman of Cambridge Energy Research Associates. "High prices, particularly if they become very high prices, will catalyze responses in supply and demand, and innovation," he said.
Indeed, just five years after their 1981 peak, oil prices slumped, prompting then-Vice President George H.W. Bush to lament to Saudi leaders about how that was hurting the Texas economy. Eight years after Iraq's invasion of Kuwait drove prices up again, the Asian financial crisis pushed them to new lows.
But many oil experts say that this cycle isn't like earlier ones. A few argue that world oil is running out. Others note that China and India's economic advances and the growth of U.S. suburbs and exurbs have built in oil demand, even at high prices. Moreover, between 2005 and 2015, China and India's populations are expected to grow by about 240 million. That could soak up new production capacity that Saudi Arabia is currently adding.
In addition, countries rich in oil have not been fully exploiting their reserves. War-torn Iraq is producing almost 2 million barrels a day less than its 1970s peak. Production has declined in Venezuela because of government disputes with workers and foreign oil firms. Insurgents in Nigeria's oil-rich Niger River delta have kidnapped foreign oil workers and attacked installations, forcing companies to suspend about 700,000 barrels a day of production. In Mexico, United Arab Emirates, the Caspian Sea and elsewhere, maintenance and weather has at times curtailed production.
Supply and demand might not respond as usual. Ironically, high taxes in Europe that helped reduce consumption in past years now dilute the effect of rising crude oil prices. And high taxes in producing countries mean that oil firms don't get much more incentive to explore as prices rise. At a recent conference in Moscow, one oil executive said that, above certain thresholds, Russian taxes siphon off $19.15 of a $20 a barrel price increase.
OPEC may have also miscalculated. Its most moderate members -- Saudi Arabia and Kuwait -- trimmed production a year ago to prop up then-sagging oil prices at $55 to $60 a barrel. According to the International Energy Agency, Saudi output has been running about half a million barrels a day lower than last year. Saudi Arabia may have delayed a production boost this fall out of fear -- wrong so far -- that the recent credit crisis would slow the U.S. economy.
OPEC countries maintain, however, that the recent run-up in oil prices isn't their fault and point to speculators. "What more can we do?" asks Nader Sultan, an oil consultant and former president of state-owned Kuwait Petroleum Corp. "The taps are open."
The power of traders and investors over the vast oil market has been growing since the early 1980s. Until then, international oil companies had long-term contracts with exporting countries that established prices and volumes. Relatively modest amounts of oil were traded daily on what was known as the spot market.
But after the two 1970s oil shocks and outbreak of war between Iran and Iraq, that system broke down. An ill-disciplined OPEC stopped setting prices and struggled to stick to output quotas to manage prices. Gradually prices declined, because of more efficient use of oil in industrialized countries and extra output from non-OPEC countries and OPEC's swing producer, Saudi Arabia.
In March 1983, the century-old New York Mercantile Exchange started a market for crude oil that has grown steadily. Now most major oil companies simply peg their sales and purchases of crude oil to the fluctuating prices on the exchange.
"I can't explain why the price is where it is today," Henry Hubble, Exxon Mobil vice president of investor relations, said Thurday during a press call about the company's earnings. "The market is going to dictate . . . and we're a taker of those prices."
Exxon has a spacious trading floor in Fairfax, Va., where about 80 people trade crude oil and another 80 trade products. But they don't negotiate prices; instead they try to take advantage of oil quality differences, tanker locations and tiny gaps between markets to meet Exxon's refinery needs as cheaply as possible. The final prices are set relative to those on the New York Mercantile Exchange or similar markets on the day of delivery.
One surprise about oil prices: So far, the economy seems to be coping. Despite an average crude oil price of $75 a barrel, the economy grew at a brisk 3.9 percent pace in the third quarter. Unemployment is low, and inflation is modest.
By contrast, the oil price spikes in the 1970s fueled high inflation and weakened growth, a combination known as stagflation.
Improved automobile mileage, more efficient manufacturers and greater reliance on services have made the U.S. economy more resilient. The United States now uses half the energy it did in 1980 for every unit of economic output. Energy costs make up a smaller portion of household budgets than in 1981.
In a recent paper, "Who's Afraid of a Big Bad Oil Shock?" Yale University economics professor William Nordhaus credited smarter monetary policy and better general economic conditions. Moreover, he said, in percentage terms, the oil shocks of the 1970s were much bigger than the steady price increases since 2002.
But Nordhaus wrote before the latest jump in prices, and many economists are wondering how high will be high enough to hurt the broader economy. Since 2000, oil prices have quadrupled.
Robert Rubin, who repeated that "markets go up, markets go down" while he was President Bill Clinton's Treasury secretary, said last week that "when oil was at $35, people said $60 oil would have tremendous effects on the economy, and at $90 we still have robust growth." But he added, "there comes some point where we will feel that vulnerability to high oil prices."