Thursday, July 03, 2008

Q&A: Record oil prices


Oil prices have hit record highs above $145 a barrel and have more than doubled in less than a year.

There have been calls for oil producers to increase supply.

However, they blame the high prices on speculators and the weakening US dollar, which makes oil a more attractive investment.

Why are oil prices so high?

Economists will tell you that prices are set by supply and demand and, indeed, at the heart of the rise in oil prices are what are known as the fundamentals.

Demand for oil has been growing as Asia's power-house economies such as China and India fuel their rapid economic expansion.

Barrels of oil
There are many factors that influence the price of oil

At the same time, there are all sorts of worries about the supply of oil.

A lot of the world's oil comes from somewhat unstable countries, so every time oil workers are attacked in Nigeria or Iraqi oil facilities are damaged, people get concerned about the supply of oil.

So fundamentally, people are worried that demand may be growing faster than supply, and oil is such an important commodity that they are prepared to pay more and more for it if they are worried.

That all sounds pretty simple then

Well it would be if everybody had exact figures for the fundamentals that influence oil prices.

The problem is that nobody knows exactly how much oil there is in the ground, many producers are a bit cagey about admitting how much they have taken out and we do not know how much oil is in tankers being shipped around the world.

On top of that, we do not have reliable figures for how much oil most countries have squirreled away in case of emergencies or indeed exactly how much oil is being consumed.

So what determines prices is not the fundamentals but everybody's perceptions of the fundamentals.

That means that when proper figures, such as the weekly US inventories figures, are released, undue weight is placed on them because few countries are so transparent.

But other than that it's just like any other commodity?

Unfortunately not.

First of all there is the Organisation of Petroleum Exporting Countries (Opec), which controls 55% of the world's oil exports.

The idea is that its members only raise or lower their production when all the other members do.

It does not always work, but it certainly means that oil is not a free market.

Also, there is a finite amount of oil in the world.

The oil that has been taken out of the ground first is the easiest, and therefore cheapest, to access.

As oil prices rise, it becomes financial viable to spend more to extract oil that is in trickier places to mine.

But as the available oil is depleted, the price will naturally rise because it is harder to find and more expensive to mine.

In addition, when there is talk about supply being threatened by unrest in the Middle East or storms in the Gulf of Mexico, how much of a problem these factors will actually be is generally a guess.

So is it unfair to blame the speculators?

The speculators certainly have a part to play in all this.

To an increasing extent, financial institutions are trading in oil as an investment like shares or currencies.

Rocket in North Korean parade
Should North Korean rocket testing really have affected oil prices?

They buy oil contracts in the hope that their value will go up before they sell them.

Alternatively, if they think the price will fall, they may sell oil contracts they do not have and buy them later, in time to settle the deal.

Even those who believe that the market is based on fundamentals accept that the participation of speculators has created greater volatility in the market.

Factors that in the past might have moved the price by a few cents could now move it by more than a dollar.

It has also given sudden relevance to factors that in the past would not have moved oil prices at all.

What sort of factors?

Events such as rocket testing in North Korea have been cited as reasons for the rising price of oil.

But it is hard to imagine how it could have any direct effect on its supply or demand.

In a market with such a serious shortage of reliable information, as long as enough people believe that a factor will affect the oil price, it will.

And in some cases the effect of factors have been reversed.

How can that happen?

Up until less than a year ago, a weakening US dollar would have been seen as a sign of weakness in the US economy, which would have meant that demand for oil was likely to fall and so the oil price would fall.

But recently, many traders have believed that some people are treating oil and the dollar as alternative investments.

So, if they think the dollar is falling they will buy oil instead and if they think oil is falling they will buy dollars instead.

Because people believe this to be the case, a negative relationship has built up between the oil price and the dollar.

Whether people are actually treating the two as alternative investments is no longer important - what matters is that people believe that they do.

But a market based on so little concrete information and so much belief is vulnerable to people changing their minds.

Related article:
What is driving oil prices so high?