The following analysis (on the "flip") is over a year old, but I still think it's worthwhile as the analysis hasn't changed much. A a few tweaks:
1) Substitute "$75 per barrel" in place of "$60 per barrel"
2) World oil demand grew 1.3 million barrels per day in 2006 and is forecast to grow 1.5 million barrels per day this year. That's a bit lower than was being projected a year ago.
3) World spare capacity is higher than it was when we wrote this briefing. Today, it's probably over 2.4 million barrels per day, although most of that is in Saudi Arabia and is somewhat questionable.
If oil demand growth is lower than a year ago, and spare capacity is higher, then why are oil prices $15 per barrel higher than a year ago? On the spare capacity front, it's highly qustionable whether Saudi Arabia really has what it claims to have, yet is not choosing to produce the oil even at extraordinarly high prices of $75 per barrel. That raises the serious question, does Saudi Arabia really have this spare capacity?
Second, while demand growth is a bit lower than a year ago, it's still strong. It's also still pushing up against the "vertical supply curve" we talk about.
Third, OECD oil inventories in terms of "days supply" are trending towards the low end of the "normal range." Low inventories are often associated with high oil prices, ceteris parabis.
Fourth, the dollar has declined sharply against the Euro and other currencies over the past year. According to Forbes Magazine:
Most commodities are priced in U.S. dollars. As the dollar depreciates, it takes more dollars to price a commodity at what the market believes it's worth. A weak dollar also makes commodities more attractive to foreign investors, who find they can buy more of a product for less.[...]
A $75 barrel of oil and a $3 gallon of gas have a certain amount of dollar depreciation priced into them, according to Axel Merk, president of Merk Hard Currency Fund...
Fifth, there's the influence of speculators, many of whom are attracted - according to Petroleum World - to "long-term positions, in which the buyer or seller of a commodity agrees to delivery at a relatively distant date in the future." Petroleum World adds that "By buying oil futures contracts long, these investors hope to sell them later at a higher price."
Finally, the "geopolitical risk premium" may be even higher today than it was a year ago, with focus in particularon U.S.-Iranian tensions and the potential for trouble in the Strait of Hormuz region. Around 17 million barrels per day of oil flow through that narrow straight near Iran, which makes it a key world oil "chokepoint" and a significant source of concern in the event of U.S.-Iranian hostilities.
With that, here's an analysis that Greg P. and I wrote last March for...well, let's just say for someone we're all very fond of. :)
Prepared by Lowell Feld and Greg P.
March 23, 2006
Q. How did oil prices go from the low $20s per barrel in 2002 to over $60 per barrel today?
A. Several factors have caused this tripling in oil prices. First, there has been a surge in world oil demand, particularly from China and "other Asia." In 2004, Chinese demand alone increased by 1 million barrels per day over 2003, far above the historic average growth for China of 500,000 barrels per day. Overall, world oil demand is expected by the US Energy Information Administration to grow by about 1.5 million barrels per day in 2006, and 1.8 million barrels per day in 2007.
Second, this increased demand has run into a "vertical supply curve" for oil; in other words, supplies have been constrained due to the lack of spare production capacity in Saudi Arabia and elsewhere. Today, the world may only have about 1 million barrels per day of spare capacity - all in Saudi Arabia - and this is mainly "heavy, sour" crude that is not easy to refine into gasoline and other light products.
Third, there have been a series of relatively small disruptions to world oil supplies since late 2002, including the December 2002 strikes in Venezuela, intermittent problems in Nigeria since early 2003, and the loss of 1 million barrels per day from pre-war Iraq production. The combination of all these outages could be adding as much as $10-$15 per barrel to the price of oil, given a rough "rule of thumb" of about a $5-$7 per barrel increase for every million barrels per day knocked offline.
Fourth, geopolitical instability and fears of terrorism have created an "anxious market psychology" environment. This might be adding $5-$10 per barrel to the price of oil.
Finally, the short-term elasticity of supply for oil is low, meaning that high oil prices don't bring on new production quickly. Over time, the elasticity is higher, but there are questions about how much oil the Saudis and others can produce.
Q. What are the basic features of today's world oil market?
A. First, oil is a world commodity and is considered "fungible," or interchangeable. For that reason, a disruption anywhere affects prices everywhere. Also, "fungibility" means that it's not particularly important where exactly you get your oil. Second, the United States continues to consume nearly 25% of the world's total oil consumption, or about 21 million barrels per day out of 85 million barrels per day total. Third, the United States imports about 60% of its oil. Top suppliers to the US include Canada, Venezuela, Mexico and Saudi Arabia. Fourth, the United States is considered a "mature" oil province, which means that fields are largely tapped out and that U.S. oil production is highly unlikely to increase in coming years. Fifth, around two-thirds of proved, conventional, liquid crude oil reserves are located in the Persian Gulf. Canada has large reserves of "oil sands," but these are expensive to produce ($20 or so per marginal barrel) and require large volumes of natural gas, which is in high demand for power plant and petrochemical use in the United States and elsewhere.
Q. Why are gasoline prices so high?
A. In the United States, crude oil prices account for most of the price of gasoline, so when crude prices increase, so do gasoline prices. In contrast, taxes make up only about 20% of gasoline prices (this varies state by state). In other developed countries, taxes make up around 70% of gasoline prices. Another factor in the United States is that the country's gasoline market is actually a series of balkanized regional markets, each with its own particular environmental specifications. This reduces "fungibility" of gasoline within the United States and can result in local/regional price spikes in the even to refinery fires, outages, etc. Finally, the phaseout of MTBE, an additive to gasoline, may cause transitional price spikes in some areas this coming summer.
Q. Is drilling in the Arctic National Wildlife Refuge (ANWR) or off the coasts the answer to U.S. oil needs?
A. No. Drilling in these areas would not fundamentally change the U.S. oil picture or the fundamental world oil market balance. In 2000, the Energy Information Administration did a study on ANWR that projected peak production of about 900,000 barrels per day in 8 years, or about 5% of U.S. oil demand at that point. This would make a minimal difference with regards to U.S. oil import vulnerability.
Q. What are the main oil related, geostrategic issues to watch?
A. First, instability in countries like Iraq, Iran, Nigeria and Venezuela. Second, terrorist threats to world oil installations, as we saw recently with the huge, critically important, 6 million-barrel-per-day "Abqaiq" processing center in Saudi Arabia. It is not well known, but the terrorists apparently penetrated deep in to Abqaiq, and failed to cause a major oil supply disruption only because of poor planning and because they panicked. That's why THIS COULD VERY WELL HAPPEN AGAIN, next time successfully. Third, increasing Chinese interest in securing oil production assets around the world, such as in Iran, Sudan, Angola, and Mauritania. Fourth, increased Chinese imports from Saudi Arabia and the Persian Gulf in general. This dependency places constraints on Chinese behavior due to U.S. naval superiority, but also provides a strong incentive for China to expand its capabilities in the Persian Gulf region. Already, China has secured basing rights in Pakistan (Gwadar) and Burma. China also has turned to Russia for oil, including a recently signed deal for an oil pipeline from Irkutsk to Daqing by 2008. Closer Sino-Russian ties are likely in the future, driven in large part by China's voracious need for energy and other raw materials. Finally, new world oil production coming online is generally in places like the Caspian Sea that are unstable and vulnerable to terrorism.
