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.Boiling Oil
March 18, 2008 |
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.
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.
Boiling Oil
Rahul Gupta (CA Final Student) (1780 Points)
20 March 2008
CAclubindia
