The old new story

also see the BBC documentary The course of oil

Ups and Downs, and Mostly Ups - What Drives the Price of Oil? by Michael Akerib:

The recent major increases in the price of oil and its derivatives such as gasoline, have affected all businesses. If fishermen and lorry drivers have been the most vocal in their protests, the tourism industry is just as likely to suffer from these new price levels. Higher airfares threaten to severely affect both airlines and the hospitality industry - particularly if predictions of further rises to $250 per barrel turn out to be correct. Airbus and Boeing are already feeling the sting with fears of postponement or cancellation of orders.

It is therefore important to understand the drivers behind the recent price movements.

Traditionally the factors affecting the price of oil have been grouped into fundamental, geopolitical and 'other' categories.

The two most important fundamental factors at present are the demand and supply balance and the value of the US dollar.

Supply and demand

While the market appears to be balanced today, the US government is convinced that an increased production would lead to lower prices. However, the Saudi government's announcement that they would increase production from 9.5 million to 10 million barrels a day did not contribute to any dampening of the prices.

The world's largest producer and exporter fears that if the prices maintain themselves at levels above $100/barrel, that the present recession will deepen leading to a downward price spiral that would lead to a significantly lower income for the producing countries. They also fear that a further drop in the American currency would severely affect the Saudi kingdom's reserves. An even worse threat is that a stabilization of oil prices at a high level would spur the introduction of biofuels that would replace oil in a significant manner.

Not everyone, though, is convinced of the ability of the Saudi kingdom to increase its production levels in a sustainable manner.

The country has, until recently, been loath at opening new deposits as forecasting market demand is extremely difficult in the oil market. Some of the Saudi deposits may well contain high sulphur or heavy crudes that are difficult to sell.

Saudi Arabia plans to open the Khurais complex by 2010 - the first major oil field opened in the last 40 years - at a cost of $15 billion. This sum is small compared to the investment that would be required to develop Saudi's potential offshore field.

Other countries too have difficulty in increasing, or even maintaining, their capacity. Thus, Russia, which accounted for 80% of the growth of supply from non-OPEC countries over the last few years, seems unable to maintain its present production level and, for the first time in the last ten years, production in the country fell. Mid-term prospects, however, are optimistic as new Siberian fields are put into production. However, global warming is affecting drilling activities in Siberia as the lack of ice makes it difficult to transport equipment as roads are non-existent on many areas.

Major investments are required to keep production at present levels. They are estimates at $1 trillion over the next 20 years for Russia alone.

Other non-OPEC countries, such as Mexico and Norway, have also been unable to sustain production levels.

More generally, production in a large number of countries is decreasing due to the age of the wells. This has led to a widespread belief in the theory of a peak in crude oil production and discovery.

The peak oil theory was first expounded in 1956 and its inventor, Mr Hubert, stated that US oil production would peak in 1970 - and it did.

Not everyone agrees, and among them the world's leading oil consultancy - CERA. Some experts believe we are not running out of oil, but out of production capacity for a variety of reasons such as lack of investments and trained manpower.

Another important set of actors weighing on the crude oil market, and they are new compared to the traditional actors in previous oil crises, are the car drivers of the emerging economies, such as China and India, that have access to subsidized gasoline and who are therefore relatively unaffected by major rises at the pump and have thus no incentive to save fuel. Demand is increasing faster in countries with high subsidies. China alone will spend this year around $40 billion to subsidize the price of gasoline.

Indeed, the major imbalance today is on gasoline rather than crude. Refineries prefer light oil - used to produce petrol and diesel - to heavy oils that goes into the production of fuel oil used mainly for heating.

Iran, for instance, a major producer of heavy oil, stocks large quantities, that they are unable to sell, in vessels moored offshore.

Price increases in the retail market will probably lead refiners to increase their investments to treat heavy oils, and this may well decrease prices by increasing availability at the pump.

As prices of oil rise, oil producers invest some of the funds locally, expanding the economy, and thus their own oil consumption, leaving a smaller part of their output available for export. This, in turn, leads to price increases.

Prices at the pump in oil-producing states, with the notable exception of Norway, is usually tax free - it is, for instance, of US$0.20 per gallon in Venezuela - and this leads to a fairly unrestrained consumption, further reducing quantities available for export.

Even though China and India have recently increased the domestic sales price of petrol which remains, however, highly subsidized.

The elements above are exacerbated by more fundamental issues such as a lack of qualified petroleum engineers and a need for new infrastructure. Recent graduates from emerging countries are arriving on the employment market but essentially join national companies in their own countries rather than joining one of the majors.

The actors

Among the biggest players on the oil market today, are the so-called 'new 7 sisters' which are Aramco, CNPC, Gazprom, NIOC, Petrobras, Petronas and PdVSA.

Banks and other financial institutions such as hedge funds are also major players on the futures markets with the oil producers accounting for less than half the volume. More specifically, index funds attempt to beat certain indexes and therefore need prices to increase. The total volume invested in index funds has grown 20 times over the last five years. They see oil as a refuge from a weak dollar.

This has led some political leaders from US presidential candidate Barack Obama to India's Petroleum Secretary to ask for the halting of oil futures trading, which they believe to be manipulated by the speculation from large institutional players. This, however, is most unlikely to happen. US regulators also consider imposing limits to trading positions, including on those taken by US investors on foreign markets.

A number of politicians have blamed 'speculators' who are switching their holdings from traditional assets such as stocks and bonds to oil futures, particularly on the NYMEX - the New York Mercantile Exchange. Indeed, the number of trades is twenty times bigger than it was five years ago. This represents eight times the imports of the US. However, it is not clear if speculative action is responsible for the increase in prices or rather if the increase in prices has driven speculators to the market.

The US is about to introduce legislation that would limit the positions that investors can take on futures markets.

Comparisons have been made with other commodity markets where increased activity is uncorrelated with price movements. Further, some commodities that are not traded on futures markets have risen even more abruptly than oil. Oil future traders do not take delivery of physical product and therefore cannot weigh on prices as they do not hoard product.

The US dollar

US imports and consumption are responsible for a massive transfer of capital from the US to the oil producing countries, in particular to OPEC countries which supply 40% of the world's oil.

The drop of the US dollar against all convertible currencies has been a contributor to the price increase of the barrel of oil, producers seeking to maintain a stable price in their domestic currency.

Every increase in interest rates on the Euro led to an almost immediate increase in the price of oil, in parallel with a drop in the dollar.

The OECD scenario forecasts that the share of OPEC countries in global production will increase from the present 40% to 52% by 2030. Should the price of oil keep rising, this would translate into substantial increases in the flow of funds towards the member countries.

The fall of the dollar translates into lower income in national currency for the producing countries. Nevertheless, the rise of the oil prices has fueled an economic expansion in the Gulf and attracted more foreign workers. Due to a shortage of living space, this has, in turn, driven up rents and consequently inflation.

Since the currencies are pegged to the dollar, the oil producers in the Gulf are not free to apply an anti-inflationary policy as it would increase the value of their currency.

Kuwait has already pegged its own currency to a basket. The risk is a run on the dollar as sentiment against the currency builds.

Seen from the eyes of buyers, countries with currencies appreciating against the dollar may well be tempted to build stocks.

A global economic crisis would reduce oil needs and dollar flows from the US, thus strengthening the currency.

For the present, however, gold, which has traditionally been the traditional investment product that acts as a refuge against a falling dollar, fear of political disruption and inflation has been replaced replaced, by oil.

Geopolitical factors

The geopolitical factors include the political situation in Iran, Iraq and Nigeria, resource nationalism, sea lane security, the risk of terrorism as well as climate change.

The major fears are, of have been, in the recent past:

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the disintegration of the Middle East, whether by Turkish incursions into Iraq or by an all-out war between Shias and Sunnis
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more specifically the fragility of the Saudi monarchy, seen as the insurer of world oil production in case of shortfalls, and the possibility that Al Qaeda may gain power in that country and stop oil exports. The geographic concentration of both production (in a single large facility) and shipment (two oil terminals) makes disruption of the flow of oil possible
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supply disruptions in Nigeria
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supply disruption from Venezuela
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the fact that the vast majority of the large oil suppliers are politically unstable
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a US military intervention in Iran. The country is the world's fourth largest oil producer but also could take action to block the Hormuz straits through which a major part of the world oil trade is channeled.

Analysts calculate that these fears have put a premium of $25 to 50 on the barrel.

Whenever fears drive markets, the latter tend to become unreasonable particularly when stocks are low and producers are unlikely to significantly increase production short term.

The future

Forecasts on the price for the next year or two vary considerably depending on the assumptions made by the forecasters, and any way forecasting the future price of oil is a perilous exercise at best. Historically, attempts at prediction have lacked precision.

The world's population will certainly continue to increase and their mobility needs are not likely to decrease. The International Energy Agency forecasts a 35% increase in oil consumption by 2030, which translates in additional requirements of 11 billion barrels of oil.

Saudi Arabia is presently restructuring its economy to become a major producer of energy-intensive industrial products. Its energy consumption has increased by nearly 25% over the last 3 or 4 years.

It is unlikely that the uncertainty surrounding international relations will decrease and this votes in favor of sustained prices.

While the majority of the players, including the futures markets, forecast continuing price increases, some of the best known experts believe the price will inevitably drop to below $100 as recession settles in, leading to reduced demand, coupled with the introduction of biofuels and of other sources of alternative energy on a major scale. Changes in the behavior of consumers, particularly in the US, would also go in the same direction.

Further, high oil prices should encourage research for new wells and technological progress in reducing extraction costs of deposits that presently are not economically exploitable.

Another effect of high oil prices would be the slowing of the globalization process with preference given to local products which would not reflect higher transport costs.

The tourism industry has therefore entered an era of increased uncertainty calling for a wait-and-see attitude regarding new investments.