April 18, 2006
Running out of gas
A year ago, I predicted that oil prices would fall to around $40 a barrel this spring. Today’s (paid-subscription) Wall Street Journal has perhaps the best article I’ve read on why I got it so wrong—and why today’s $71 oil price has very little to do with the supply-and-demand fundamentals that until recently drove the market:
In contrast to past bull markets in crude, this year’s run-up has occurred even though oil inventories in the U.S., the world’s largest market, have swelled to their highest levels in nearly eight years.
… The answer to the puzzle posed by rising prices and inventories, industry analysts say, lies not only in supply constraints such as the war in Iraq and civil unrest in Nigeria and the broad upswing in demand caused by the industrialization of China and India. Increasingly, they say, prices also are being guided by a continuing rush of investor funds into oil markets. Institutional money managers are holding between $100 billion and $120 billion in commodities investments, at least double the amount three years ago and up from $6 billion in 1999, says Barclays Capital, the securities unit of Barclays PLC.
The flow of money into oil, analysts say, has been prompted by a spreading belief that demand for oil will continue to rise with global economic activity as supply tightens under the influence of several factors – among them, the West’s escalating nuclear standoff with Iran; growing political violence in oil-rich Nigeria; and more broadly, steadily growing global economic activity. The three-year bull run in oil has been underpinned by strong global demand for fuel coupled with a prolonged shortage of spare capacity to pump and refine crude.
… One reason for the anomaly of rising oil inventories amid rising prices is temporary. Even as crude stockpiles have swelled, U.S. inventories of gasoline have fallen as refiners have shut down operations to perform maintenance and prepare to meet new government-mandated fuel formulas. Higher gasoline prices give a further lift to crude prices because refiners are willing to pay more for low-sulfur, gasoline-rich varieties of oil, such as the U.S. benchmark light sweet crude.
… Analysts say that behind the flush U.S. inventories lies a new trend born of the extended run-up in oil prices. Refiners of crude, who once sought to hold lean inventories, and traders, many of whom prefer to flip paper rather than buy and hold actual oil, are now grabbing more than they used to.
Since early 2005, the crude-oil market is in what traders call “contango,” meaning futures contracts for a given product are priced higher than that same good for near-term delivery. The price of oil to be delivered four months from now is about $3 more than oil to be delivered next month.
In short, it pays for refiners and other oil-market players to buy and hold oil now to sell it down the road. Making that trading opportunity possible, says Colorado-based oil analyst Philip K. Verleger, is the huge volume of new buyers on the other side: investors who he estimates have put more than $60 billion into U.S. crude-oil futures since 2004.
… The last time U.S. inventories were at today’s levels, in 1998, the market was about to crash. By the end of 1998, prices fell below $11 a barrel from an average $18.32 in December 1997.
A crash looks unlikely now, both because supplies remain tight and because of the large volumes of money that investors are pouring into oil markets. Money managers such as pension funds are investing in commodities to diversify away from stocks and bonds, and appear willing to buy commodities through passive, index-linked investments at ever-higher prices. But if the investment tide turns, prices could fall quickly.
During their meeting in Vienna last month, officials from the Organization of Petroleum Exporting Countries expressed concern about rising inventories and the growing role of financial players. Their fear: Money flows could reverse on the proverbial dime, while any move by the cartel to reduce supply would take months to affect markets.
OPEC also fears a return to “backwardation” – the opposite of contango – with near-term prices higher than long-term contracts. Such a flip-flop could prompt speculative buyers to dump inventories; prices could quickly drop $20 a barrel or more, OPEC officials said.
“More and more people are going to recognize that the fundamentals just aren’t there to support these prices,” said John Gault, an adviser to the energy industry with Geneva-based firm Nalcosa.
Which is what I’ve been saying all along. Pity about my timing, though…
UPDATE, 04/19/06: Another angle to consider about sky-high gasoline prices.
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Great article, great info. It's interesting to read an in-depth article on this subject rather than a bunch of man on the street interviews blaming big oil for everything.
Posted by: hammer at April 22, 2006 7:14 PM
Thanks for the WSJ info, I'm too cheap to pay for it but love getting it when I can.
This confirms what I was wondering about the role of speculation in today's prices and how it's changed over the last ten years. And it helps clarify the role of the oil companies in price setting which, if the article is correct, doesn't seem to be as much as many believe.
I think people also forget how much of an impact Katrina truly had on our ability to refine our oil and get it to market.
Posted by: ChatterBug at April 20, 2006 9:55 PM
Wow. I must say this article blew me away. I had no idea that there were so many factors affecting oil and gas prices. I find it disheartening that responsible journalists haven't broadcast this information to the general public. I guess it's just not as sensational as "gas prices at all time high...who do you blame?". Most of course simply blame the oil companies and cry price gouging -- which I now see is definitely not the case. Thanks for shedding some much needed light on this!
Posted by: Joel at April 20, 2006 8:45 PM
Great article...very insightful...wish more people would understand these issues...it's so much more complex than most of the media makes it out to be (Bravo WSJ)! Nevertheless, I don't think we can ignore the effects of Katrina and Rita...at least those of us down here in Louisiana can't. We are paying the high prices at the pump too...but I think most in this area appreciate the oil companies rather than recklessly blame them...the jobs and stability that the industry provides down here (both production and refining) are vital to our (eventual) recovery.
Posted by: Nola at April 20, 2006 8:08 PM
Thanks for this post; very informative. It's interesting to see how other factors (speculation, environmental happennings, etc.) are causing gas prices to skyrocket--not the oil companies gouging the prices to hurt consumers.
Posted by: Rachel at April 20, 2006 1:15 PM