Explaining the oil price surge

The following news analysis by me from Fund Strategy identifies the key factors in determining the oil price.

The big debate in relation to surging oil prices is whether speculators are to blame. There is a sharp divide between those who see speculation as a key factor in rising prices and those who point to more fundamental forces.

Before getting to the core of the argument it is worth dealing with the more lurid versions of the debate. This is necessary to avoid arguing at cross purposes.

The first problem is that the term “speculation” has different meanings. For some it conjures up conspiratorial images of evil oil sheikhs and rapacious hedge fund managers playing in a giant casino. But it is not necessary to indulge in such stereotypes to believe that speculation in some senses is going on. In the more sober sense “speculation” means that financial factors other than those related to supply and demand are affecting prices.

Another misconception is that speculation and fundamental factors are mutually exclusive. The key question is which ones, if either, are playing the dominant role.

There are also some factors on which there is a widespread consensus. For example, the weakness of the dollar has played some part in rising oil prices. Since crude is typically priced in dollars, if the American currency falls that alone makes oil more expensive.

Having disposed of some of the key misconceptions it is possible to get to the core of the argument. This involves looking at each of the key factors in turn – demand, supply and speculation – to try to work out the relative importance of each.

Demand: There is an almost instinctive sense among many pundits that rising demand must be the key factor in pushing up prices. Surging economic growth in emerging market economies is seen by some as self-evidently the main cause of rising prices. But it is wrong to make such an assumption before examining the evidence. On the contrary, it is conceivable that rising supply could outstrip rising demand so prices could fall even if more oil is being consumed. Nor can financial factors be ruled out before looking at the facts.

When it comes to examining oil demand it is easier to identify past trends than to predict the future. Peter Davies, until recently the chief economist at BP, said there was no evidence of significant shifts in medium-term growth trends in either supply or demand. In June he told a Lombard Street Research seminar on oil prices that: “The growth rate in demand is not out of the ordinary. There is a steady long-term trend overall.”

What seems to be worrying the markets is not past demand but the prospect of a surge. Predictions are always fraught with difficulties, as they depend on assumptions about such things as economic growth rates and energy efficiency, but it looks likely that demand will continue to rise strongly. Although demand from the developed countries could dip in the short term, that from the developing world will continue to rise. The annual report from the Organization of the Petroleum Exporting Countries (Opec) estimates that 90 percent of the increase in global oil demand between 2006 and 2030 will come from developing countries.

Supply: If demand is often the focus of the discussion of the oil price the supply side is often neglected. Yet one should not be considered in isolation from the other.

Few industry experts argue that there is a shortage of oil in an absolute sense (although many environmentalists do). If there is a problem it is not to do with crude in the ground but with the investment needed to harness it.

Much concern is focused on non-Opec production. For example, the growth of Russian oil supplies peaked in 2003 and Mexican oil production is declining. Overall oil exploration rates are declining and fields are running out of oil.
In addition to the exploration and production side of the business it is necessary for oil to be refined before it can be used by consumers. In this respect capacity is not rising as fast as previously expected.

Over time the higher price of oil is likely to stimulate more investment in exploration, production and refining of oil. But such investment takes commitment and can have a long lead time. There could be a significant investment but long time lags are likely.

Speculation: Different sets of experts do their sums on supply and demand in different ways and come up with different conclusions. For the International Energy Agency (IEA) the supply-demand imbalance is enough to account for surging oil prices but for Opec it is not. The key missing element in the discussion is speculation.

Advocates of the importance of speculation point to the huge increase in oil futures trading. This is taken to indicate a rise in speculative activity. But others argue that there is no necessary reason why surging futures trading should affect oil’s spot price.

The critics of the speculation thesis also point to other markets, such as iron ore, where prices have surged but there is no speculative market. Another argument is that speculation would be expected to push up inventory levels as those betting on higher oil prices hoarded physical oil. Yet there is no evidence in the available figures that inventories are at unusual levels.

Opec, in contrast, conceded that speculation should push up inventories in theory but points to limitations in the data. It says that lack of data could be hiding such increases. Others have even argued that keeping oil in the ground, rather than pumping it, could be seen as a form that inventories take.

It is not possible at this stage to give a definitive answer on the relative importance of different factors pushing up oil prices. More work on the demand-supply imbalance is necessary before reaching firmer conclusions. But it does look likely that the difficulties in bolstering supply are a relatively underdeveloped part of the discussion.