Why Are Oil Prices So High?
Several reasons — but a new era of high prices is not upon us.
National Review
— Frederick P. Leuffer, CFA, is senior managing director and senior energy analyst for Bear Stearns & Co. Inc.
The sharp rise in oil prices to $37 a barrel has coincided with a number of significant events involving geopolitics, macroeconomics, and the petroleum industry. These have piqued the interest of investors and have caused many portfolio managers to ask whether this is the start of a new era of sustained high oil prices.
Is it? No. But to understand why, here are the most common questions being asked about oil on Wall Street, followed by the answers more people should know:
What role is the weak dollar playing in oil pricing?
Largely, it is a psychological and speculative role. So far, the weak dollar has had no impact on supply, demand, or inventories. For example, no producer has cut oil production because the dollar value has declined. Although OPEC has cited erosion of buying power due to the currency shift, and has given this as a reason to justify the current high barrel price, OPEC production (excluding Iraq) is estimated to have increased each month between October and January, with members persistently exceeding quotas.
Is fast growth in Chinese oil demand the impetus behind rising oil prices, and won't this result in sustained high oil prices?
Estimates of Chinese oil demand in 2003 and so far in 2004 are hovering in the 8 to 10 percent range per annum. This compares with an average growth rate of 6.5 percent from 1992 to 2002. By any measure, this growth is significant. If it persists at this level of growth, China might be responsible for higher world oil demand. But this may or may not result in sustained high oil prices depending on changes in supply and inventories. More, put in perspective, China's oil consumption is about the same as Japan's, one-quarter of the U.S.'s, and one-third of Europe's. Also, China's accelerated oil demand is at least partially offset by a slowdown in demand growth rates in Japan, Europe, Russia, Latin America, Africa, and the United States.
Why is the U.S. government filling the Strategic Petroleum Reserve (SPR) when oil prices are so high? When will this stop and what will happen when it does stop?
Following the 9/11 terrorist attacks, President Bush decided to fill the SPR to its authorized level of 700 million barrels for national security reasons. Since then, 103.8 million barrels have been added, and the SPR now holds 647.5 million barrels. Since last April, following the allied invasion of Iraq, the fill rate has averaged over 1 million barrels a week, or about 1 percent of U.S. crude oil demand. Obviously, this program is not sensitive to oil prices. At the current pace, the fill would need to go on for about another year to reach the 700-million-barrel target. Given the budget deficit, the high oil price, and the presidential-election season, the administration should cease purchases sometime in the first half of the year — which would have the same impact as a sudden 1 percent drop in crude oil demand, causing prices to fall. (Other countries are also building their SPRs, which may also be playing a role in the speculative fervor behind the oil-price rise.)
Are rising finding-and-development costs leading to higher oil prices?
Not likely. F&D costs are cyclical and have risen from a low point. But historically, costs are not that high right now.
Are we running out of oil?
No.
But hasn't oil production been disappointing for the major oil companies?
Yes. However, some of the reasons for the disappointing production are complicated and do not suggest oil supplies have been constrained. To begin, there is a difference between production growth and production growth relative to expectation. In 2002, for example, BP's oil-production growth rate was a “disappointing” 4.5 percent relative to company expectations of 5.5 percent, even though BP's rate outstripped the growth rate for world oil demand seventeen-fold. Of course, oil companies make more money with higher oil prices and therefore prefer this environment, even though they show lower production volumes. Oil company volumes are also influenced by OPEC quotas and production, and it is difficult to time many of the factors that influence production — such as new field start-ups, maintenance, labor strikes, and weather delays.
Does the fact that Persian Gulf nations conduct a low level of exploration mean they don't have much exploration potential? Will these countries be able to supply more oil when the world calls for it?
OPEC production is constrained by demand. Utilization for Saudi Arabia, for example, is 75 percent. Since Saudi Arabia has not been able to produce anywhere near current capacity (except for very short periods) for decades without causing a sharp downturn in oil prices, it certainly does not make sense to expand capacity further.
Going forward, OPEC will not be required to supply more oil. Rather, its production and market share will continue to shrink as has been the case since the early 1970s. Rising oil production from non-OPEC sources combined with the growth in alternative energy and market-share-grab by other fuels will force OPEC to reduce output over time. High oil prices in the past three years will only hasten this process.
If OPEC is cheating on quotas and overproducing, as the oil analysts say, why haven't inventories built to high levels?
Inventories have built, but probably not as much as forecasted by analysts. And again, part of the build has been undertaken by government SPRs. Adjusting for the slower-than-expected inventory-build in the first quarter of 2004 may mean that OPEC needs to cut production by about 2.3 million barrels a day — which will be difficult for OPEC to do.
So — why are oil prices so high?
Today's high prices are owing to low commercial inventories and speculation. Again, inventories are not low — in fact, total crude-oil inventories in the U.S. are at the highest level since 1995, when oil prices were $18 a barrel. It's just that crude-oil traders have chosen to focus only on commercial stocks and have ignored oil in the SPR. The level of inventories today is consistent with a barrel price in the mid-to-high $20s.
Speculators take into account many variables, including terrorism, currencies, faith in OPEC, and momentum. Put yourself in the shoes of an oil trader. Would you leave the trading pit on a Friday night with a large net short position and risk the event of a terrorist strike that could push oil prices higher over the weekend? While the decline in the dollar has had no impact on oil supply, demand, or inventories, traders cite dollar weakness as a reason to be bullish. This stems from speculation that the dollar will keep falling and that eventually it will become attractive for consumers outside the U.S. to purchase higher quantities of oil.
Finally, after three-and-a-half years of high oil prices, with prices spending most of that time within OPEC's target-price band, OPEC has credibility. Crude-oil traders see no strong reason to doubt that OPEC will cut production to balance the market in the next two quarters, just as the organization is promising. Traders feel that there will be time to short crude-oil futures if OPEC does not do what it says. But for now, why not go with the flow.
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