a non-Jones theory of oil prices

["Devine, James" <jdevine@xxxxxxx>]

May 17, 2004


The Factors Behind Higher Oil Prices


 


By REUTERS



 

LONDON, May 17 (Reuters) - U.S. oil prices set another record on the New York Mercantile Exchange on Monday, reaching $41.85 a barrel, the highest [in nominal terms] since NYMEX launched its crude contract in 1983. 

Average U.S. prices of just over $36 a barrel so far this year are the highest in nominal terms since 1981, according to BP. 

Following are some of the factors behind oil's price surge. 

-- LOW INVENTORIES, OPEC MARKET MANAGEMENT 

Oil companies have sought to become more efficient and free up capital by holding lower stocks. This has given the industry less of a cushion against sudden supply disruptions. 

A wave of mergers following 1998-1999's price crash also reduced the number of companies holding inventory. A series of supply disruptions last year -- the war in Iraq, Venezuela's general strike, and ethnic unrest in Nigeria -- cut into stocks. 

OPEC, which controls around half the world's exports, has worked hard to stop stocks building, especially in the United States, during periods of seasonally weak demand. Ministers have announced plans to cut production before prices start to weaken, giving refiners no chance to replenish stocks with lower-priced crude or products. 

The resulting lack of stock cover leaves refiners more vulnerable to supply disruptions and increases the likelihood of price spikes. This in turn has attracted heavy buying interest from big-money speculative hedge funds. 

"OPEC strategy has shaped oil markets into a bullish machine in a tense international environment," said consultants PFC Energy. "This has caught the attention of speculators and hedge funds, who have magnified the current pressures in oil markets." 

OPEC policy has helped create the conditions for a sustained price backwardation, pricing physical oil at a premium to future supplies. So refiners are discouraged from holding storage and buy at the last minute. 

--POLITICAL TENSIONS IN OIL PRODUCING NATIONS 

Political tensions in the Middle East and violence in Iraq have undermined traders' confidence in security of supply from the region, which pumps a third of the world's oil. Iraqi exports, not long back to pre-war volumes, have been hit by sabotage attacks. Traders fear there may be more disruptions in the run-up to the June 30 handover of power. 

Traders fear Islamic militants could target oil infrastructure in OPEC's biggest producer Saudi Arabia. Shootings at a Saudi petrochemical plant fostered fears of a larger attack on the kingdom's tightly-protected oil facilities. 

The post-September 11 chill in relations between Saudi Arabia and the United States has raised concerns that Riyadh may no longer be willing to act as a guarantor of cheap oil as it did during the 1990s. 

"While the Kingdom remains the ultimate guarantor of oil supplies in case of emergency, it has given up its role of price moderator inside OPEC," PFC Energy said. 

Venezuelan oil production is still suffering the fall-out of the strike 18 months ago that cut capacity. A possible August referendum on Venezuelan President Hugo Chavez' rule could again destabilise exports from a big U.S. supplier. Civil unrest in OPEC member Nigeria is another flashpoint. 

--STRATEGIC RESERVES BUILD 

Supply security concerns have spurred many countries to increase strategic inventories, withdrawing supply from an already tight market. 

The United States continues to fill its strategic petroleum reserve despite high prices. Other countries including India, South Korea, Taiwan and China are building reserves or plan to start soon. 

--RISING DEMAND 

China's economic expansion has given a dramatic boost to world oil demand, sucking in crude and refined products from all around the world. Unless China's economy overheats, traders expect its fuel demand to keep growing for the next two or three years, encouraging speculative hedge funds to bet that high oil prices are here to stay. 

Chinese oil demand looks set to rise about 20 percent in the first half of this year, says the International Energy Agency, on top of 11 pct growth last year. 

At the same time, sharper growth in the U.S. economy, which devours a quarter or all world oil, is driving competition between Asia and the U.S. for supplies. 

The rate of demand growth has caught forecasters such as the International Energy Agency by surprise. Consumption forecasts have proved far too low, encouraging OPEC to keep supplies even tighter than needed to prevent stocks building. 

Higher demand means that a shortage of refining capacity that has plagued the United States for the last four years has now spread to Asia, again leaving the global oil supply system more exposed to disruption. 

--REFINERY BOTTLENECKS 

Environmental regulations are pushing up the price of making fuel, forcing companies to build expensive new facilities and making it harder to ship supplies between regions. 

In the United States, individual states demand an array of different gasoline blends. This makes it harder to transport supplies between states and to import supplies from abroad. 

Environmental regulations have made it more expensive to build new refineries, and much harder to get the necessary permits. 

The United States accounts for about 45 percent of world gasoline consumption. Demand is up because of the growing numbers of low-mileage-per-gallon sports utility vehicles on America's highways. 

U.S. gasoline demand drives a growing requirement for high-quality light, low-sulphur crude. China is competing for those grades of oil to meet demand for transportation fuels, lifting the price premium for low sulpur crude. Most of OPEC's crude is heavy and high-sulphur. 

--SCARCER OIL 

Big oil reservoirs are becoming harder to find and more expensive to develop. Many of the oil provinces outside OPEC are mature, which means that finds are now smaller, need more costly technology to develop and fall faster from peak production. 

Oil companies have also been cautious on spending since the '97-'98 price crash slashed their share prices and triggered a spate of mergers. They have focused on large-scale projects, which will give them good margins. 

Many new ventures are in remote areas, which demand expensive equipment and are more susceptible to delays. 

Non-OPEC supply growth outside Russia before the price crash averaged more than one million bpd. Since then it has been negligible. 

Forecasts of non-OPEC supply growth, especially when the rebound in Russian production is stripped out, have consistently been overstated. 

The increased cost of finding and developing non-OPEC oil has fuelled speculators convictions that oil markets are a good long-term bet. Royal Dutch/Shell's (RD.AS)(SHEL.L) reserves troubles have reinforced the view that oil is becoming harder to find. 

In OPEC, which holds around two-thirds of the world's oil reserves, many of the bigger nations either do not allow foreign investment in oil, or have unattractive investment and legal terms. 

This has slowed down production capacity growth in OPEC nations, meaning that most are already producing flat out. Only Saudi Arabia holds substantial spare capacity, giving it even more leverage over prices. 

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Mark Jones' stress on Mother Nature as the main cause of the oil price hikes (which still aren't as the last peak in real terms, I'm told) is only one part of the above picture. The picture also misses factors pushing oil prices down, such as increasing efficiency in the use of oil (not to mention unexploited efficiencies).

 

Jim Devine