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Sat, 04 Sep 2004

JP/Part 1 of 2: Fundamentals, not speculators, main cause of oil price turbulence

Part 1 of 2: Fundamentals, not speculators, main cause of oil price turbulence

Kurtubi, Jakarta

Last week the price of WTI (West Texas Intermediate) crude was recorded close to US$50/barrel, a record high, but a level still far lower in real terms than that registered in 1979 -- about $40/barrel (at the U.S. dollar rate in 1979) -- or the equivalent of $80/barrel at today's value of the US dollar. Obviously, last week's price of "only close to" $50/barrel was "nothing" in comparison with the price level recorded 25 years ago.

In reality, the high price last week has not yet brought about the kind of shock that the world previously experienced as a result of the soaring prices of oil. The first oil shock, in 1974, was a result of the oil embargo imposed by oil-producing Arab countries. And the second shock, which resulted from the outbreak of the Iranian Revolution, brought about a major impact on the economic condition in advanced countries grouped together in the Organization for Economic Cooperation and Development (OECD).

The OECD countries underwent a drop of between 3 percent to 5 percent in their economic growth, a condition leading to rising unemployment and an increase in inflation. In addition to long lines at gas stations in Europe, Japan and the United States, winter was particularly harsh as many people could not afford to turn on their heaters.

In 2004, however, the drop in economic growth and the rise in the inflation rate among OECD member countries has not been as serious as it was in the 1970s. In other words, $40/barrel is still tolerable to their economies.

Unfortunately, many parties, including policy makers in OECD countries, have made statements as if the oil price at the present level were already so high that it would be necessary to take action to lower it. They argue that the oil price today is far above the level that they believe constitutes a market equilibrium price, i.e. about $22-$28 per barrel, the reference price range of the Organization of Petroleum Exporting Countries (OPEC) prices.

In fact, in view of the highly dynamic developments in the world's oil industry and market, the oil market equilibrium today has changed compared with the situation just five years ago, when OPEC set its price range at between $22 -- $28.

One gets the impression that it has taken OPEC very long to understand the development and changes in market equilibrium, particularly in regard to the changes in the highly rapid growth of international oil consumption, particularly in these past two years.

As a result, at present, many OPEC members are still busy expressing their hope that the price of oil will again fall within the OPEC price range of $22 -- $28 once speculators reportedly maneuvering in the oil market stop.

In their opinion, the fact that the oil price has risen close to $50/barrel is not the consequence of the supply and demand fundamentals but, rather, the result of speculators' maneuvering to scoop up great profits from the steep price hikes. To ensure that the blame will not be laid on OPEC, the speculators have been made scapegoats! At certain times, the market can also be said to be the culprit for this unfavorable condition in the international oil market.

Estimates of Oil Market Equilibrium (In Million Barrels per Day)

2003 Quarter Quarter 2004 Quarter 2005

III/2004 IV/2004 I/2005 World Demand79.2 81.2 84.082.084.084.0 Non-OPEC Supply48.8 49.0 49.749.750.050.2 OPEC Supply27.0 29.0 30.029.030.130.0 Balance (inventory, NGL, Condensate, etc)

3.4 3.24.3 3.3 3.9 3.8

Note: Calculated by CPEES on the basis of various sources such as OPEC, Deutsche Bank, DOE, etc

Is it true that the recent oil price hikes are the result of speculators' maneuvering? If we read a recent report of the U.S. Commodity Futures Tradition Commission as quoted in various mass media publications in the West, the allegation that many parties in OPEC have made does not seem appropriate. The reason is that in the period when the basket oil prices of OPEC rose about $12/barrel, from about $30/barrel in April 2004 to about $42/barrel in August 2004, the long (purchasing) position of the speculators/players in the NYMEX oil exchange was relatively unchanged.

In April 2004, the "long" position reached about 47.8 million barrels for crude and about 83.7 million barrels for crude and oil products. In August 2004, this "long" position was recorded at 47.9 million barrels for crude and about 84.1 million barrels for a combination of crude and refinery products. So, in the period when there was a price hike of about $12/barrel (April -- August 2004), the activities of speculators/players on the NYMEX oil market did not undergo any visible changes. This shows that the oil price hike recorded in the past four months was not the result of any maneuvering by market players.

At this juncture, it is true that the perception of market players has affected the transactions in the oil market. However, the impact of this speculation will last very briefly. This speculation will certainly be corrected by the real power of supply and demand for a longer term.

In other words, the increase in oil prices, which started as early as 2002 and was followed by steep price hikes this year, is actually the outcome of the working of the market fundamentals, namely the power of supply and demand, in which the growth rate of demand has exceeded that of supply.

This phenomenon has arisen because of weak investment in the upstream sector of the international oil companies while the demand has shown an increasing inclination, particularly in the case of China with its population of over one billion, where the growth rate of its oil demand far surpasses its economic growth rate of 8 percent.

The writer is the Director of the Center for Petroleum and Energy Economics Studies (CPEES), and is a lecturer in the postgraduate program at the University of Indonesia's School of Economics.