Consumer Energy Report is now Energy Trends Insider -- Read More »

By Robert Rapier on Oct 28, 2007 with no responses

$90 Oil: How We Got Here

David Ivanovich at The Houston Chronicle always does a nice job of covering the energy markets. His latest article gives a comprehensive overview of the events of the past few years that put us on the cusp of $100 oil (I actually dreamed last night that we hit $100 this week, which means I am thinking too much about it):

Factors converged to send oil prices gushing

On the catalyst that kicked off the price rise in 2004:

WASHINGTON — China’s electricity grid was near the breaking point in the spring of 2004. Facing repeated blackouts, Chinese exporters, clustered in the southern province of Guangdong, fired up their own diesel-powered generators.

China’s petroleum demand rocketed up 15 percent that year — catching world oil markets unawares. Though oil prices had begun to rise the previous year, that surprise demand from China helped propel crude costs along a trajectory in which prices have nearly tripled in just 3½ years, oil analysts say.

On OPEC’s historical role:

In 2002, OPEC had nearly 6 million barrels a day in spare production capacity. That started melting away in 2003, hitting a low point of about 1 million barrels in 2005.

For years, OPEC oil ministers struggled to keep prices within a band of $22 to $28 a barrel for the cartel’s basket of crude grades — comparable to about $24 to $30 a barrel for West Texas Intermediate, the U.S. benchmark. The fear was that if oil stayed above $30 a barrel for any length of time, the world economy would be tipped into recession. Such concerns seem almost quaint today.

As oil prices began to climb, OPEC officials came to realize high prices would not lead to “economic Armageddon,” said David Hobbs, vice president and managing director of global research for Cambridge Energy Research Associates.

OPEC abandoned its price band.

Of course as I have argued before, if OPEC does have spare capacity, as I think they do, they are playing a dangerous game with the world economy. At some point, the “economic Armageddon” may in fact materialize.

On the role of the falling dollar and instability:

The dollar’s long descent against the euro and other world currencies also has played a key role. Worldwide, oil is priced in dollars. When a dollar buys less, oil producing countries raise prices to maintain their purchasing power. Book estimates that about $17 of the current price of oil can be attributed to the weak dollar.

Political instability has always played a role in the price of oil. Estimates of the “security premium” factored into a barrel range as high as $30 or $40, Hobbs noted. Four years of war in Iraq — where production has yet to match pre-invasion levels — and rising tensions with Iran also have taken their toll.

Last week, Harvard University professor Linda Bilmes told a House panel the Iraq war may account for $5 to $10 of the price of a barrel of crude.

On the role of speculators:

In recent weeks, for instance, traders have been spooked by Turkey’s clashes with Kurdish rebels in northern Iraq. But fighting in that region could justify a run-up of maybe $1 or $2 a barrel, not the $7 or $8 per barrel seen in response, Book said.

Some analysts attribute the difference to speculation, hedging and other financial maneuvers that skew the market. Book argues that market fundamentals can explain an oil price of perhaps $65 a barrel, with political risks pushing that up to $70 or $75 a barrel.

But with the markets carried away by what Book calls “the emotions of the mob,” many oil traders expect oil prices could zoom up to $100 a barrel in coming weeks. “What people are doing is pricing in yesterday’s expected catastrophe and adding in tomorrow’s expectation of greater catastrophe. But that’s a funny way to count,” Book said.

I have been thinking lately that there is a Catch-22 in the markets right now with respect to inventories. If refiners want to wait out the current high prices by drawing their (high) crude inventories down some, the speculators say “Inventories are crashing! Not enough supply!” Then they bid up prices. If refiners choose to pay the current market prices, then they are helping support that demand at current market prices.

And of course the ever-rosy future price projections:

Oil analysts surveyed by Bloomberg forecast oil prices will fall to an average $65 a barrel next year and below $56 a barrel by 2010. But as Edward Morse, chief energy economist for Lehman Brothers, noted, analysts have been making that prediction for several years.

I mentioned two of those analysts a couple of essays back: Fadel Gheit and Daniel Yergin. Both have been consistently wrong on the direction of oil prices, and yet they are still the two main “go to guys” when someone wants an opinion on the direction of oil prices.