Tuesday, April 18, 2006

Oil Bubble? 

The price of oil is spiking upwards yet again and is setting new highs almost daily. Certainly this is a good thing for oil exporters such as Venezuela. The additional revenue that comes from these high prices will translate into more economic growth and more social spending.

The $64,000 question though is where is the price of oil going from here. Will it continue to climb, stabilize, or fall abruptly? Of course, no-one knows the answer to that. But evidence is mounting that the current high prices owe more to speculation than actual fundamentals of supply and demand and that prices could therefore be set for a big drop. Here are some excerpts from an article in today's Wall Street Journal:

Oil Settles Above $70 a Barrel, Despite Inventories at 8-Year High

Crude oil closed above $70 a barrel for the first time, highlighting a phenomenon reshaping the petroleum world: invasions flows into oil futures are supplanting nitty-gritty supply-and-demand data as prime drivers of prices.

In contrast to past bull markets in crude, this year's run-up has occurred even though oil inventories in the U.S., the world's largest market, have swelled to their highest levels in nearly eight years.


The answer to the puzzle posed by rising prices and inventories, industry analysts say, lies not only in supply constraints such as the war in Iraq and civil unrest in Nigeria and the broad upswing in demand caused by the industrialization of China and India. Increasingly, they say, prices are also being guided by a continuing rush of investor funds into oil markets. Institutional money managers are holding between $100 billion and $120 billion in commodities investments, at least double the amount three years ago and up from $6 billion in 1999, says Barclays Capital, the securities unit of Barclays PL.

The flow of money into oil, analysts say, has been prompted by a spreading belief that demand for oil will continue to rise with global economic activity as supply tightens under the influence of several factors - among them, the West's escalating nuclear standoff with Iran; growing political violence in Nigeria; and more broadly, steadily growing economic activity. The three year bull run in oil has been underpinned by strong global demand for fuel coupled with a prolonged shortage of spare capacity to pump and refine crude.

"What's been happening since 2004 is very high prices without record-low stocks," says Jan Stuart, global oil economist at UBS Securities. "The relationship between U.S. inventory levels and prices has been shredded, has become irrelevant."

It remains to be seen whether this belief in a paradigm shift that permanently buoys oil prices will stand the test of time.


A crash looks unlikely now, both because supplies remain tight and because of the large volumes of money that investors are pouring into oil markets. Money managers such as pension funds are investing in commodities to diversify away from stocks and bonds, and appear willing to buy commodities through, passive, index-linked investments at ever-higher prices. But if the investment tide turns prices could fall quickly.

During their meeting in Vienna last month, officials from the Organization of Petroleum Exporting Countries expressed concern about rising inventories and the growing role of financial players. Their fear: Money flows could reverse on the proverbial dime, while any move by the cartel to reduce supply would take months to affect markets.

OPEC also fears a return to "backwardation" - the opposite of contango - with near-term prices higher than long term contracts. Such a flip-flop could prompt speculative buyers to dump inventories; prices could quickly drop to $20 a barrel or more, OPEC officials said.

"More and more people are going to recognize that the fundamentals just aren't there to support these prices," said John Gault, an adviser to the energy industry with Geneva-based firm Nalcosa

Along with the article was a nice chart showing U.S. commercial inventories of oil climbing from about 260 million barrels to 346 million barrels over the past two years.

I have to say, this does very much look like a speculative bubble. Which means oil prices could drop very abruptly.

What does this mean for Venezuela? First, it is unlikely to have any immediate impact. Even if prices dropped tomorrow Venezuela would still do well at least this year. Oil invoices are typically paid after 90 days so they would still be paid at the current high rate at least for the next 3 months. Further, much of the oil is actually sold on long term contracts. That means when oil prices spike upwards Venezuela isn't necessarily getting the benefit of that as much of the oil is still sold at an already agreed upon price. But the reverse is also true. An abrupt drop in prices wouldn't completely devastate Venezuela's revenue stream as it would still be able to sell a fair amount of oil at prices that are locked in.

More importantly though, this does show that Venezuela and Iran were right to push for production cut-backs at the last OPEC meeting. They correctly saw that although prices were pushing higher the market itself was oversupplied and inventories were increasing. Sooner or later that will lead to an abrupt drop in prices. It is hard to predict when the drop might occur but when it happens it will be very fast - prices would be back down to $20 per barrel in a matter of months with OPEC not being able to counter that drop.

Clearly the prudent thing to do is for OPEC to cut back now to stop this buildup in inventories and forestall a price drop. Unfortunately the other OPEC members shot a proposal for cutbacks down. Their reasoning was that with prices so high how could price boosting cuts be justified. Certainly it would get them a lot of bad publicity. Worse than that, it would probably make the price bubble even worse for a while as traders used production cutbacks as an excuse for further speculation.

So what to do? One idea might be for OPEC to agree behind closed doors to production cutbacks but not announce it publicly. That way they wouldn't feed the speculative frenzy yet they would get some of the overhang off the market and help stop the build up of inventories that will send prices crashing down. Who knows, maybe they did do that and we, of course, just don't know it.


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