Boiling Oil

March 18, 2008 |

If it was simply supply and demand that explained the price of oil, it would not be topping $109 per barrel, as it did this past week.

With supply of the black gooey stuff in abundance and high prices holding demand in check, it's fairly obvious that market speculation lies at least partially behind oil's dizzying rise. Bearing little relation to its fundamentals, the price of oil has gotten way ahead of itself, and I'd argue that investors ought to be wary in this bubbly oil market.

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Supply Soaring Over Demand
Despite record high prices, oil markets are well supplied, and inventories are healthy. According to the U.S. Energy Information Administration (EIA), crude inventories surged by 6.2 million barrels in the week ending March 7. Meanwhile, gasoline levels have hit a 15-year high. Production is also set to jump. High prices have prompted more drilling and opened up new opportunities in once marginal areas like Alberta's oil sands and Venezuela's Orinoco Belt. What's more, new rigs are more productive and new technologies can squeeze more out of oil fields.

High oil prices are pulling back demand. U.S. oil consumption fell by 1.3%, according to BP's (NYSE:BP) most recent annual review. Despite China's consumption growing at 6.7%, global consumption grew by just 0.7% that year.

The EIA reckons the weakening U.S. economy, higher product prices and increased use of corn-based ethanol are expected to keep U.S. demand essentially flat in 2008. Meanwhile, the government of China's decision to slap a mandatory 10% fuel price hike ought to temper demand in that country.

Underlying Factors
The price of oil has nothing to do with production costs. Many Persian Gulf producers have production costs of less than $10 per barrel. Outside of OPEC average costs are roughly $10-30 per barrel. With per-barrel production costs at around $35, Alberta's oil sands region is one of the most expensive places to extract oil. But even with these costs, at today's prices, oil sands producers still enjoy a hefty profit. Oil prices can take a big drop without making oil companies uneconomic.

Why Oil Why Now?
A month ago, oil stood at just a tad over $88. Besides price, nothing much has changed since then. Sure, geopolitical threats loom in places like the Middle East and Nigeria, but that's nothing new. If anything, oil market fundamentals are softening. So, why is it trading well above the three digit mark? Quite simply, lower interest rates, now threatening an already weak dollar, are fueling a push into commodities, notably oil. In the midst of shaky equity and credit markets, investors are turning to black gold as a safer bet. Bets made on future price movements have become self-fulfilling as more and more traders jump in.

Expectations
Speculators are pouring big money into the oil market, pushing the price way beyond where it should be. In the market frenzy, traders are paying little attention to supply and demand fundamentals. That kind of speculative, herd activity leaves oil vulnerable to a potentially big downward correction. Investors today should steer clear of oil until that correction happens.

Although the finiteness of the earth's oil supply means that peak oil is inevitable, technological innovations in finding and drillng for oil have delayed the appearance of peak oil on several occasions. For example, the National Center for Policy Analysis states:

In 1855, people could only access whatever oil happened to seep to the surface, and an advertisement for Kier's Rock Oil stated, "Hurry, before this wonderful product is depleted from Nature’s laboratory."

In 1874, the state geologist of Pennsylvania, the United States' leading oil-producing state, said that all the oil would be gone by 1878.

In 1920, the U.S. Geological Survey stated that the world only had 60 billion barrels of oil left.

In 1950, geologists estimated that the world had 600 billion barrels of oil.

In 1970, scientists estimated that the world had 1,500 billion barrels of oil.

In 1994, the U.S. Geological Survey estimated that the world had 2,400 billion barrels of oil.

In 2000, the U.S. Geological Survey estimated that the world had 3,000 billion barrels of oil.

None of this means that new oil is forming, or that peak oil will never happen. It means that newer technological advances allow us to find and recover more oil, though later estimates are based on unaudited claims by countries that withhold field production data and are therefore inconclusive.

So wait till the next major finding, crude will be back to USD 50's / b

Find above.

The COLORS reflect different levels of OIL CONSUMPTION (per country, not per capita -the key is on the left).

The map's sources are identified as the BP Statistical Review Year-End 2004 and the Energy Information Administration