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What’s Really Fueling Those Sky-High Oil Prices

There are lots of theories; most of them are right

By Fred Yager
ConsumerAffairs.com

June 29, 2008

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Ask any number of experts about what’s causing the current run-up in oil prices, now around $140 a barrel, and you’re likely to get several different answers.

1. It’s still just supply and demand. That’s what many, including Warren Buffet, believe.

2. It’s the speculators whose mere prediction that the price will go up makes it happen.

3. It’s the ongoing instability of the Middle East such as the war in Iraq and the tension over Iran.

4. It’s weakness in the U.S. dollar, a currency to which the price of oil is tied.

5. It’s fear that -- you name it -- the world is running out of oil, terrorists will disrupt the pipelines, another hurricane will halt offshore drilling.

6. Or, as Ralph Nader sees it, the reason behind high oil prices is greed among oil-producing companies and countries who feel they can charge as much as they want for oil and we’ll still pay it.

The real answer? Sorry to say it's all of the above, which makes it difficult to point a finger and say, “There’s the culprit!”

So we decided to do the next best thing and call on veteran oil analyst Mike Rothman, formerly of Merrill Lynch and now senior managing director and head of integrated oil research at International Strategy Investment (ISI). Mike has been studying the oil market for more than a quarter of a century and he says the seeds to the current run-up in oil prices were planted in 1999.

“That was the tail end of the price crash that pushed oil down to $15 a barrel,” says Mike. “It caused OPEC countries, led by Saudi Arabia, to develop an aversion to low oil prices so they micro-managed the oil balance to produce an average oil price for OPEC crude of $25 at barrel, which at the time amounted to a 67% increase.”

The 2nd Gulf War

The next critical milestone came in 2003 when we invaded Iraq.

“The widely held view going into the war was that oil prices would collapse,” he explains. That didn’t happen. Just prior to the war, Venezuela’s oil workers went on strike, shutting off 90% of that country’s daily output of six million barrels. “Then we lost all of Iraq’s 2.5 million barrels a day when the war started in March 19,” says Mike.

“A month later riots in Nigeria’s cut that country’s production almost in half and when the smoke cleared global inventories were lean, about 120 million barrels below their five year average. Soon, oil was heading toward $30 a barrel.”

Meanwhile, Saudi Arabia decided to hold off on any projects to add oil supply capacity because the Bush White House was pronouncing that after the war it would work to pump up Iraq to five million barrels a day.

When Concern Replaced Reality

“From there, it seemed that we had an incredible string of events which dramatically shifted market perceptions about oil availability,” says Mike. “In fact, the rally in crude prices that started in early 2004 primarily reflected concerns about oil availability as opposed to actual availability. It is this phenomenon of concern being a price driver that caused a major disconnect between oil prices and actual oil inventories.”

In late 2003, Shell Oil wrote down a portion of its oil reserves in what Mike says was “later was deemed an accounting scandal from one of their officers who basically committed fraud.” He adds that the reserve write-down was, in fact, the seed which sparked the re-emergence of what is known as “Peak Oil,” or the concern that oil production had hit its peak, at least in that particular area.

“Plus, in 2004, we had two particular events which played into growing worries about oil availability,” Mike points out. “The first was a huge jump in oil demand growth rates, notably from the developing world, China and India in particular. The other occurred in Russia and was known as the Yukos debacle.

"The basic story was that one of the oil czars was imprisoned and his oil company, Yukos, was gutted simply because he backed candidates running against President Putin. This triggered a concern, (there’s that “C” word again), that there would be a 10% annual decline in Russian oil production, pushing oil prices even higher, even though the decline never occurred.”

Then in 2005, something happened that had a real impact on oil production. Hurricanes Denis, Katrina and Rita took more than one million barrels per day out of production. This drained oil industry resources. The devastation from those hurricanes disrupted what had been an upturn in the exploration and production cycle.

Financial Factors

At some point in the past few years, says Mike, there arose two financial factors that have nothing to do with supply and demand but still impact the price of oil.

One involves what Mike calls “the commodities as an asset class” trading boom among speculative investors which caused crude prices once again to be appear at odds with fundamentals. The second involves oil being used as a “store of value” related to a weakness in the value of the US dollar.

“Before 2007, changes in oil prices and changes in the dollar were unconnected,” says Mike. “But then last July, which just happened to coincide with the sub-prime mortgage mess, we saw a pattern emerge. Changes in oil prices correlated almost exactly with changes in the dollar. As the value of the dollar decreased the cost of oil increased.”

So today, we have $140-a-barrel oil which translates into having to pay $4 plus for a gallon for regular gasoline. As high as that is, drivers in other countries such as England and Australia have been paying more for several years.

Going forward, Mike believes eventually that global oil demand is going to weaken and that we’ll see an increase in spare capacity, which should dampen prices considerably, especially as OPEC expands production capacity. Some analysts are predicting $100 a-barrel oil by the end of the year. Still, we could see more increases before that happens because of speculative trading and the concern about oil availability.

Mike also says he has “little confidence that U.S. lawmakers will take meaningful steps to 'drain liquidity' from the oil as an asset class trade.

As he put it, “Washington seems intent on 'looking busy' versus actually acting meaningfully.”

That’s something we should all be concerned about.

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