Monday, May 17, 2004

The Price of Oil: What Price is Right?

The Christian Science Monitor discusses the dynamics in the oil and gasoline market. It's notable that most of the short-term fixes such as using the Strategic Petroleum Reserve would be futile and expose us to strategic risk down the road.

By Ron Scherer | Staff writer of The Christian Science Monitor

NEW YORK – With oil and gasoline prices moving to uncharted levels, a lot of people are looking for a way to make filling up the gas tank less painful.
Some US senators want to tap the Strategic Petroleum Reserve as a way to lower the price of crude oil. OPEC is talking about increasing production. A consumer group wants the Bush administration to open up an investigation into the competitive practices of the oil companies. At least one book predicts current prices "may be the preamble to a major crisis."...

Last week, that confluence pushed oil prices to their highest noninflation-adjusted price ever: $41.38 a barrel. On the futures markets, gasoline prices also hit all time noninflation-adjusted highs. The stock market was pummeled as traders worried about the economic effect.

"We're just seeing continued worries about gasoline production," says John Kilduff, an oil trader at Fimat USA. Last week, for example, a power outage hit a Louisiana refinery, cutting production for only a short time. As soon as the news hit the market, however, the price of gasoline leaped 5 cents a gallon. "The market is on tenterhooks," says Mr. Kilduff.

Some executives in the oil industry think such speculation is driving the oil markets. Bill Greehey, the CEO of Valero Energy, a large refiner, says there is no good market reason for the high prices. If the hype were removed from the markets, he says oil prices would fall $5 a barrel overnight. And since crude oil represents half the cost of gasoline, he says that would quickly reduce pump prices.

Oil traders have been particularly alarmed by the relatively low level of gasoline inventories despite the fact refineries are operating at 96 percent of capacity. However, the industry says it expects to get by. "We will be light on inventory this summer but if things go OK we should be OK," says Bob Slaughter, president of the National Petrochemical & Refiners Association in Washington. "We've been able to meet demand so far."

Oil experts have been surprised that imports of gasoline have not filled the gap in the US. John Felmy, chief economist at the American Petroleum Institute, wonders if some of the offshore refiners have been slow to meet new US standards on the amount of sulfur allowed in gasoline.

"We have heard the importers were petitioning the EPA to change its stance and the agency decided not to," he says.

In fact, Mr. Slaughter says the domestic industry won't be able to produce much more. "There's been no new capacity in the last three years," he says.

Higher demand, up 3 percent so far this year, is one of the factors behind the tighter gasoline supplies. "The higher demand this winter meant we didn't have an opportunity to build a cushion for gasoline," says Dave Costello, an analyst at the Energy Information Agency (EIA) in Washington.

Energy prices are continuing to rise despite the fact OPEC is planning to meet next week in Amsterdam to discuss increasing production. "It looks like they are trying to come to a consensus to increase their quota level by 1.5 million barrels per day," says Kilduff.

However, analysts believe OPEC members are already cheating on their quotas and are producing an extra 2 million barrels of oil per day. "So that means if they increase their official quotas there is no new net oil on the market," says Mr. Felmy.

Only a month ago, Saudi Arabia lowered quotas. Now, the Oil Kingdom, with almost the only spare capacity around, is one of the leading proponents to increase output. "They see the $40 price as hurting the global economy," says Kilduff.

To get more oil on the markets, some in Congress are looking at the nation's Strategic Petroleum Reserve (SPR). During the budget debate last month, Sen. Carl Levin (D) of Michigan and Sen. Susan Collins (R) of Maine included language that asked the administration to stop filling the SPR. It passed but had no affect of law. This week, Sen. Charles Schumer (D) of New York is expected to ask for the release some of the crude from the SPR as President Clinton did during an oil spike.

One consumer group, Public Citizen, is asking the administration to investigate what it terms the "uncompetitive practices by large companies operating in the US."

In a recent study, the watch-dog group examined the impact of recent mergers on oil industry market share. "We found in the last 10 years there is a huge concentration in refining capacity ownership," says Tyson Slocum, the research director. "That increased market share has made it easier to do anticompetitive practices."

Spiking oil prices have become part of campaign rhetoric. Last week, the Kerry campaign accused the White House of having no plans. Scott McClellan, White House spokesman, says the president "remains concerned about rising gas prices."

Some energy experts believe the price of oil may be close to peaking. The EIA is projecting the national average for gasoline will hit $2.03 a gallon in June. Mr. Costello doesn't see the price falling below $1.90 a gallon for the rest of the summer. The highest price for gasoline was in 1981 when it hit $2.99 in today's dollars.

Other analysts, however, see higher prices. Kilduff expects prices to peak near Memorial Day at around $2.15 a gallon.

Market forces are already working to reduce prices, says Mr. Zandi. He points to an increased number of oil rigs in the Gulf of Mexico and increasing supplies from the Caspian Sea region. "The energy industry has been distracted by the mergers and acquisitions and accounting scandals," he says, "but all that is changing."

At the same time, he says the strong demand for oil in China should slow as that country's economy loses steam. He expects the US as well should slow from its 5 percent growth pace. "I think next year crude oil prices will be closer to $30 a barrel than $40," he says.

The comments of Mr. Zandi are correct, it's entirely possible that with a simple economic slow-down story in China the price of oil could slip to a more reasonable $30 pb light sweet crude. However, what he is not taking into account the other dynamics in play. As this story by Richard C. Leone and Bernard Wasow illustrates, the finance side of the economies as reported by the CSM also impacts what the oldman has been citing for some time - the role of the dollar currency valuation in the price rise of oil.

Experts have a lot of good reasons to explain it, among them unrest in the Middle East, gas-guzzling cars, and greed among oil-producing nations. But there is another culprit that is being ignored and that is making the problem far, far worse in the US: the decline in the value of the dollar.

Between the end of February 2002 and the end of February 2004, the price of oil in dollars rose by 51 percent (from $20 a barrel in 2002 to more than $35 a barrel today), but it rose by only 4 percent in euros. Over the same two-year period, the US currency plunged from 1.16 euros per dollar to 0.80 euros per dollar. In this situation, it is perfectly rational for foreign suppliers of oil to charge more dollars.

While remedies such as encouraging more efficient use of energy are good, they won't negate the fact that a declining US dollar is an important cause of the run-up in oil prices. And the Bush administration is doing little about it.

It may seem like a stretch to blame the price of oil on fiscal mismanagement, but the rise is closely tied to the falling dollar, which, in turn, is the result of flagging confidence in federal tax and budget policies. The dollar is falling, among other reasons, because of the prospect of too many US Treasury bonds on the market - and that is made necessary by the enormous deficits generated by tax cuts, spending increases, and sluggish economic performance.

Thanks to the unbalanced policies of the past few years, the US will be pumping out trillions of dollars in new federal debt. Financial markets - and oil producers - are afraid that a future glut of bonds will drive down their value and, sooner or later, drive up US interest rates. The prospects of falling Treasury bond prices and a weak dollar have depressed European demand for US Treasury bonds, so the value of the euro has risen further relative to the dollar.

Dollars today simply do not possess the same purchasing power that they did a few years ago - a situation that will persist as long as it is painfully obvious that the administration has no plan to reduce the deficit. As the value of the dollar falls, of course, OPEC raises the dollar price of oil.

So as Americans flinch when they pump ever more expensive fuel into their tanks, they might reflect on the decline in international confidence in the dollar. It is more proof of the adage, "there's no such thing as a free lunch." In terms of today's relationship between the weak dollar and oil prices, the political version of a free lunch is a buffet of tax cuts, big deficits, high gasoline prices, and blameless officials.

Officeholders can claim credit for cutting taxes while blaming mysterious international market forces for increases in oil prices - but the bill still must be paid. [emphasis added]

The link between the Treasury debt, the currency valuation, and the price of oil - and also incidentally the price of gold - is the link that I've been exploring in this series of articles. Next I'll begin discussing the fundamentals of supply in the oil market and discuss how a repositioning in the currency markets and likely monetary policy shift of the central banks of China and Japan will impact all of these markets.

The real market expected value of oil in the next year will be a combination of the fundamentals and the market pricing of various government policy effects. I'll be exploring and analyzing these exact dynamics and trying to predict their outcome in my forthcoming articles.


At February 3, 2010 at 5:40 PM, Anonymous Anonymous said...

My friend and I were recently talking about how modern society has evolved to become so integrated with technology. Reading this post makes me think back to that debate we had, and just how inseparable from electronics we have all become.

I don't mean this in a bad way, of course! Societal concerns aside... I just hope that as memory gets less expensive, the possibility of downloading our brains onto a digital medium becomes a true reality. It's one of the things I really wish I could experience in my lifetime.

(Posted on Nintendo DS running [url=]R4i[/url] DS KwZa)


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