The Causes of Soaring Oil Prices: Industry Analyst Views

Interviews with Industry Analysts

Editor’s note: In the scope of a year, the price of oil has doubled — and prices in the $90-a-barrel range are quickly becoming normalized. To gain insight into the state of the market — and industry watchers’ views on the state of the market — Multinational Monitor spoke with oil industry analysts. What emerged from our conversations was a general view that, thanks to surging demand from China and India, global supply-and-demand curves are shifting. Beyond that, there was some divergence of views on the state of the market and future scenarios.

We interviewed the following analysts: Kenneth Carroll, senior analyst, Johnson Rice & Company; Sarah Emerson, director, Energy Security Analysis Inc.; Phil Flynn, senior oil market analyst, Alaron Trading; Charles Maxwell, senior energy analyst, Weeden & Co.; Linda Rafield, senior oil analyst, Platts; Jeff Rubin, chief economist and chief strategist, CIBC World Markets; Adam Sieminski, chief energy economist, Deutsche Bank; Bob Tippee, editor, Oil and Gas Journal; Philip Verleger, president, PKVerleger LLC; Phil Weiss, senior analyst, Argus Research Group.

Multinational Monitor: Would you attribute the recent oil price spikes more to supply and demand fundamentals, concerns about Middle Eastern instability, speculation or other factors?

Bob Tippee, editor, Oil and Gas Journal: I would say that 80 percent is fundamental supply and demand tightness. Ten percent is concern about the Middle East and other geopolitical tensions. Five percent is speculation and 5 percent would be other things like the weak dollar.

Jeff Rubin, chief economist and chief strategist, CIBC World Markets: Certainly not Middle Eastern instability or speculation or so-called geopolitical factors. While that’s a convenient watch-word to attribute all of this to, the simple fact of the matter is if there was hoarding — which one would consider in geopolitical terms because people are afraid of supply disruptions — there would be large inventories of oil. But quite the contrary, inventories of oil are at record lows.
           
The story now is how many OPEC countries are cannibalizing their own export capacity. By that I mean that an alarmingly increasing percentage of their oil production is now going to meeting domestic demand as opposed to world export markets. And that reflects to a considerable extent the policies of massively subsidized oil prices in those countries, resulting in soaring demand growth there.

Philip Verleger, president, PKVerleger LLC: Most of it is due to the DOE [Department of Energy]. Speculation didn’t play a part. Start from the fact that we have just seen [in the Fall of 2007] in absolute terms, the largest price increase in history, which I find stunning. It’s the largest price increase over a 90-day period. It’s larger than the price increase we saw when Iraq invaded Iran in 1980. Larger than the price increase we saw when Iraq invaded Kuwait in 1990. That’s stunning. What happened? You look across international lines — nothing happened. And if you look at oil prices last year versus this year, they were about identical up until August 18. The path was about the same, and suddenly they went way up this year versus going down last year. And the one real change was DOE decided to put oil in the Strategic Petroleum Reserve [a U.S. government-operated reserve pool of oil, maintained in case of a national security emergency].

Adam Sieminski, chief energy economist, Deutsche Bank: The market is in a sense testing what level the prices have to go to before we can get some supply response and some reduction in demand. So far, what we are finding is that even at $3 gasoline, there is still a pretty good appetite in the United States for buying gasoline and cars. So the price keeps going up and it might keep going up until we finally get to the point where somebody says, “You know, at that price level I think I’m going to get a smaller car.”
           
There were five huge things that have happened over the course of the past few years that have driven prices very high. The first is China and India emerging as big consumers of everything, including oil. And, a very strong demand base in the United States. So that’s the first thing: China, India and the U.S. as big consumers.
           
The second thing was underinvestment in new production and refining capacity. We had a period not too long ago, just 10 years ago, when oil was $10. Everybody thought the prices would keep going down, so there was not a lot of investment in new production and refining. By the early part of this decade, that underinvestment began to haunt us.
           
The third thing is we’ve had rising geopolitical risk. We’ve had problems in places like Iran, Iraq, Nigeria, Venezuela, even Russia, you could argue. There have been issues that have come up over the past few years that have tended to constrain oil production.
           
The fourth thing has been the decline in the dollar and very low interest rates. Low interest rates promote capital investment and growth, and the falling U.S. dollar reduces revenues to OPEC producing countries, so they want higher prices. And so the combination of the falling dollar — it’s been going down for about seven years now — and low interest rates have helped to promote high oil prices.
           
The fifth item is we’ve had a sizeable pickup in both speculative and investment-grade money going into the commodities markets and that’s tended to provide support to prices, just from the standpoint of people wanting to own contracts on the NYMEX, just as an example. So that’s why oil went up.

Sarah Emerson, director, Energy Security Analysis Inc.: I don’t think that’s the best way to think about it. I think there’s a lot of writing out there that imagines that the price of oil is a layer cake, and you have all these different layers and when you add them all up you get a really high price. But it’s a much more fluid situation than that. You have days where certain factors have a much bigger impact than other factors. And sometimes you have days where several factors all hit at once and the market will move in a certain direction. And then it takes a long time, sometimes, to erase that movement. So I caution against thinking about it as, $20 is this, and $20 is that and $20 is something else.
           
I will definitely say that there are certain factors that are having a bigger impact than others. Probably the most important factors right now would be the fact that we still have very limited refining and production capacity worldwide. We’re operating at an extremely high capacity factor in all aspects of the supply chain. And that’s what moved the market from $30 to $50-plus. Now, did it move us to $55, $60, $65, $70? It’s very, very hard to make that leap, and there’s absolutely no economic theory or modeling that can take you there. So when you talk to people, you’re getting individual judgment, regardless of what they might call it.
           
Now you have a market that is much more highly sensitive to some of the other factors that are out there — what you’ve added is real sensitivity to supply and demand issues. You take that really sensitive and volatile market and you add things like all the problems with Nigeria, where they’ve had to shut in a fairly significant volume of crude oil. You obviously have the war in Iraq. You have the occasional reference to possible terrorist attacks in the Middle East. You have Turkey talking about invading northern Iraq. You have Iran and the U.S. in a standoff on nuclear weapons. All of these factors are percolating along and depending on how they are reported, they change people’s perceptions. Those perceptions come in and take this very volatile market, and you can have $5, $10, $15, $20 price moves based on these stories.
           
Then you lay on top of that — and now I’m beginning to sound like a layer cake and I don’t mean to — but you add to that the other factor, which is speculation. You have that flow of capital into energy, you have a very tight supply chain, you have investment interest in energy commodities, and then on top of that you have these news stories — which sometimes are reported very soberly and sometimes are reported in a ridiculous way — and all of these things contribute to a market that is in the $80s. And the problem with that is people say, “Well, if this factor goes away, the price will come down.” It doesn’t really work that way. You begin to live with a certain price. You live with $80, let’s say. And you live with $3 gasoline. And you live with it and you change your behavior and you change your expectations, and then it really takes an event to move the market back down, or to then move the market back up.
           
So I caution against the layer cake idea on why prices are so high.

Charles Maxwell, senior energy analyst, Weeden & Co: I would say that so long as capacity utilization in the world crude oil producing system is running at 98 percent, which it is today, and so long as perhaps one-and-a-half, 2 percent, that’s excess, is in the form of Saudi heavy, sour crudes, which the typical American refinery can’t use any more of — they use some, but they can’t use any more of because it has very serious effects in pitting the insides of these pipes and then requiring the refinery to shut down for a long time and the redoing of all the pipes — we’re going to have these periodic price rises of this sort.
           
Any system needs to have a little cushion between adversity that strikes — weather factors or cut-offs for political purposes or political struggles from civil wars. We don’t have in this system enough of a cushion. Normally, capacity utilization is considered ideal around 94 to 95 percent. So our 98 percent capacity utilization is well above that and we can’t get it down, because it takes 5 to 7 years to create it and we aren’t spending the money today that would create it 5 to 7 years out.

Phil Weiss, senior analyst, Argus Research Group: That’s not an easy question to answer, for sure. When oil prices were approaching $100, I felt pretty strongly that that was too high, that it was too much driven by some of those factors you noted. If I was to be asked to give you what I thought the fair value of oil really is, I would say it’s probably in the $60-$65 range. I think those factors are the difference between what fair value is and what it’s trading at.
           
Another factor that’s having an impact has been the weakness of the dollar.

Kenneth Carroll, senior analyst, Johnson Rice & Company: The biggest part of it has been the weakness in the U.S. dollar. Barrels are priced in dollars worldwide so when the dollar weakens the price per barrel goes up.

Linda Rafield, senior oil analyst, Platts: I think the price spike that we saw to $99.29 toward the end of November was precipitated primarily by all-time lows in the U.S. dollar. A cheap U.S. dollar makes it very inexpensive for net importers of commodities to import those commodities. The flip side of that being that for producers, it causes deteriorating terms of trade. For an OPEC producer, a very weak dollar pretty much dictates that they need higher oil prices to offset that dollar weakness.
           
I do think that some of the moves you’ve seen across the commodities sector in the last year, say in oil and gold, have been precipitated by a fairly large influx of money flows into that area. We have seen money market funds and asset managers and portfolio managers definitely putting money to work in the commodities sector, and that certainly has bolstered prices, since most of those people notoriously will trade from the long side.
           
Now do I think speculators are artificially pumping up prices? No. Speculators are a necessary ingredient of any futures market. They absorb the risk the hedgers are looking to offset. So I don’t look at them as an evil in the marketplace.

Phil Flynn, senior oil market analyst, Alaron Trading: I think we talk about speculation, we talk about geopolitical risk, but ultimately at the end of the day, it always comes down to supply and demand.
           
People sometimes get a little too excited about speculators and the market, thinking it always increases the price of oil, when the truth is it really doesn’t. In fact, an active market with a lot of speculators probably just assures that we have enough supply at the end of the day. A lot of people will say, “This isn’t about supply and demand, it’s about speculators running up the price, and these greedy traders in New York trying to make a buck.” But they said that when oil was at $25 a barrel and $15 a barrel as well, and ultimately what they didn’t acknowledge or realize was that the demand for oil was growing at a pace that we haven’t seen in years.
           
I think speculators have assured us enough supply because the futures markets create a situation where these fears about supply and demand are played out in a transparent atmosphere where people can react to prices. If prices go up too high too fast, guess what happens? Demand should slow down a little bit, and then we’ll have enough supply. So it’s very important to have an active market with speculators involved.
           
In fact, I would take it a step further. I would say that if we didn’t have an active speculative market over the last 10 years or so, if we didn’t see this record speculation, we probably would have gone into recession, we probably would have seen gasoline shortages, we probably would have seen a high unemployment rate, we would have seen business get hurt dramatically.
           
I think the speculators have done a good job in making sure we have a transparent market and we should thank them for not having shortages.

MM: Are producers able to expand supply over existing levels in the short- and long-term in order to keep up with demand?

Rubin: I don’t think we’re going to be able to get the production. Even to maintain current levels of production is going to require more and more high-cost oil like, for example, Canadian oil sands, because conventional production is depleting. And that’s not just in one place in the world. That’s happened in the huge Burgan field in Kuwait, it’s happening right now in the huge Cantarell field in Mexico, and it probably will start to happen in the biggest field of all, the Ghawar field in Saudi Arabia.

Sieminski: There is certainly no resource problem. There are plenty of resources of oil and natural gas in the ground. Peak oil theory, which says that the resource base is not big enough, in my opinion, is wrong. There’s plenty of oil. The question is getting it out in a timely and economic fashion. There’s a lot of oil in Iraq, for example. But that’s a pretty difficult place to do business right now. So is supply going to be able to keep up with demand? I would say the likelihood is that it will. And if, because of geopolitical issues, it doesn’t, then what that means is demand will have to slow down, and that probably will happen either because of higher prices, or regulations like CAFE [U.S. auto fuel efficiency] standards or climate initiatives that will tend to suppress demand.

Rafield: There certainly are concerns in that direction. The bottom line is most fields are fairly mature at this point, for example in the North Sea. If you look at the third quarter results for most of the major producers, most of their supply was down. And that actually comes into a discussion of non-OPEC supply, which has sorely disappointed the last two or three years. So if you take into account the fact that most of these fields are mature, and you have very solid demand growth from China, India and the Middle East, most likely you’re going to have to continue to draw your inventory, unless OPEC puts more oil on the market.

Emerson: Well, you probably noticed the Energy Bill. The Energy Bill has taken a huge bite out of U.S. demand growth. And we’re probably one of the more egregious consumers. So if the Chinese ever did something similar, like have a tax, we’d all be on a very different demand growth path.
           
If you said demand was going to grow in the next 20 years the way it’s grown the last 20 years, you’d worry about investment because production is getting harder. It’s in more hostile environmental locations, more and more of it is in countries that have national oil companies, you have the tar sands in Canada, you have Orinoco [a heavy oil field] in Venezuela. Producing oil right now is not a dead-easy thing, if you want to be an investor in oil production.
           
Generally speaking, in the next 20 to 40 years, I think there’s plenty of oil. I’m not in the peak oil crowd. But it’s becoming more difficult and more expensive for sure.
           
However, if it’s not business-as-usual, if we really are going to have more conservation in oil consumption worldwide — which obviously the Energy Bill suggests the U.S. is going to do — we’re going to have more alternative fuels and we’re going to have more fuel efficient cars. And we still haven’t even addressed CO2 legislation, which is coming eventually. So I actually believe that oil demand growth is shifting to a lower level. That eases up the investment requirement on the supply side and makes life a little bit easier.
           
It’s a really complicated question and I think it’s been oversimplified by the peak-oil folks. There’s really a lot more to it.
           
Tippee: Yes and yes. They, in fact, have been expanding supply. Everybody thinks it’s going down, but if you look at the supply numbers, they’re going up — they’re just not going up as fast as demand is, that’s the problem. That’s the 80 percent factor in the high prices. And supply growth, production growth, even though it’s there, always disappoints us. We always think there’s going to be more than there turns out to be.
           
So in the short term, yes, I think producers can expand supply, just not as much as the market needs. In the long term, I think producers can continue to expand supply, but again, perhaps not as much as the market is going to need. We say we’re going to need 50 percent more supply in 30 years, and I don’t think that’s going to happen and nobody else does either. But the problem is demand growth. Supply can increase, but not as much as the market seems to want it to.
           
Flynn: That’s the biggest debate going on in the world today, and some people say no, that demand is growing too much, that we’re not going to be able to keep up with that. I don’t happen to believe that, because I’m a believer in the markets. If the prices go high enough, we’re going to find a way to meet demand if we allow the markets to work, if we don’t intervene in the price of oil. Because what do high oil prices do? High oil prices encourage alternatives, high oil prices encourage conservation.