$100/barrel oil-coming soon to an exchange near you

 

$100/barrel oil has gone from sensationalist claim to credible reality. Little more than a year ago, Goldman Sachs was castigated for releasing what was then seen as a self-serving report warning that oil could see a 'super spike', with crude prices reaching as high as $105/barrel. One year on and the front month crude contract on the New York Mercantile Exchange is averaging above $65/barrel for the year to date, after hitting an all time high on Apr 21 of $75.35/barrel.

Earlier projections assumed that a serious supply disruption would be necessary to move prices so high, yet the market has reached nearly $75/barrel oil through a combination of expectations about Iran, continued volatility in Iraqi security and output and a particularly bad spate of militia violence in Nigeria.

In short, the market has reached nearly $75/barrel without the realization of a disastrous supply event, even if the previous high was a result of the massive dislocation caused by the devastating 2005 US Gulf hurricane season.

 

Chart: Correlation between open interest and NYMEX crude

Adequate supply

The physical market's lack of relevance is reflected in the loss of OPEC's ability to moderate price behavior. In addition, the price structure for international crude benchmark Brent Blend has for some time been that prices for forward delivery are higher than for prompt. This is unnatural for a high-volume low-price commodity that is expensive to store and, again, indicates no shortage of physical crude. Furthermore, crude and oil product inventories in the US and for the OECD as a whole remain at healthy levels.

Futures reflect the price of oil decided by demand for a primarily financial contract. There is nothing fundamental to the market in terms of costs of production or return on capital that decides whether the price of oil settles one day at $70/barrel, $80/barrel or indeed $100/barrel. It depends on the amount of money with which market players are willing to back long and short positions.

In the run up to the May 2 high, the movement of the IPE Brent crude contract lead that of the physical Dated Brent marker. IPE Brent's peaks and troughs were generally higher and lower respectively than Dated Brent's. Given no shortage of physical crude, the only explanation is that the physical market's leverage on price is temporarily in abeyance, or is periodically being overridden by a futures market driven by a huge influx of capital and living off future levels of risk rather than the immediate supply/demand balance.

Inflation impact

While the rise in crude prices, as well as other commodities, has broken all previous assumptions, what has been equally surprising has been the lack of impact of high energy prices on world growth. An oil shock of this proportion should have caused widespread inflation, resulting in higher interest rates, which in turn would have put a break on world trade and thus the continued rise in demand for crude.

Instead inflation in both the developed and developing worlds has pretty much been kept under control. Manufacturers have been unable to pass on increased energy prices to consumers and have instead had to accept reduced margins, which have largely been achieved through control of labor costs. This has been helped by the shift in the manufacturing base to countries like China, and has also given impetus to the process. In addition, oil prices before the recent rise were historically cheap when adjusted for inflation, which meant that the proportion of consumers' disposable income affected by a rise in oil prices was less significant during the current oil shock than previously.

However, there are signs that any slack there was has now been exhausted. Industries and economies based on raw material processing will eventually have to pass rising energy costs on to consumers. In the US, expectations about average inflation rates have risen from 2.3% in January to 2.8% in May, having already moved up from a low of 1.6% in early 2003. The expected rate of inflation is at the very top of the band with which the Federal Reserve is comfortable.

Consumers' expectations about future inflation are also rising because prices are climbing persistently faster than officially announced rates of inflation. Official price indices strip out energy costs and make other adjustments that mean measured inflation is lower than the cost of living increase experienced by families. When energy prices rise fast that anomaly becomes more readily apparent and begins to shape expectations about future inflation.

This means that there are two processes underway; the rebuilding of surplus crude capacity and the gradual slowing of demand growth as a result of substitution, but also potentially slowing world growth as a consequence of tighter than currently expected monetary conditions instigated to reign in inflation. These are slow processes and will evolve over a two to five-year time period in which physical world crude markets will stay in a delicate balance. During this period, prices will remain exposed to any disruption to supply, while price volatility will be magnified through the marginal price setting of futures markets where the link to physical markets has become increasingly elastic and erratic. As a result, $100/barrel is a real possibility.

Created: May 16, 2006

NOTE: Please note the date and price published in the first paragraph of this feature has been corrected from May 2 and $74.10 to Apr 21 and $75.35.

This is an extract from a feature article on the formation and impact of high oil prices that will appear in the June 1 edition of Energy Economist. Click on the right navigation to subscribe now.