Part 1 of 2: Fundamentals the cause of oil price turbulence

Part 1 of 2: Fundamentals the 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 Demand 79.2 81.2 84.0 82.0 84.0 84.0

Non-OPEC Supply 48.8 49.0 49.7 49.7 50.0 50.2

OPEC Supply 27.0 29.0 30.0 29.0 30.1 30.0

Balance (inventory, NGL, Condensate, etc)

3.4 3.2 4.3 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.