Where the Oil Rally Goes: Facts and Speculation

A few months ago, as the oil price was butting up against $100 and then finally going through it and then dropping back down below it, most respected oil analysts whom I read believed that the near term would see lower oil prices. Most thought early 2008 would see a retracement into the low $80s. That expectation is one reason the recent strong and consistent rally to just under $120 as of now is so dramatic.

But what comes next? How much of the last $20 is speculation and how much is fundamental? And of these fundamental factors, how temporary or how long lasting are they?

Before trying to guess at those questions, let us keep in mind the One Eternal Truth of the oil market: nobody knows anything. Well, maybe a few people know something, but you can be sure that they are not talking. The oil market is enormous; demand is global; supply is complex with a variety of types of oil; and the inventories are hard to measure.

Keeping that in mind, let’s look at the fundamentals. First is strife in Nigeria. Attacks on pipelines by the MEND rebels and threats to shut in more production could be driving near term prices to a small degree. If Nigeria were an important factor, the oil price would tend to drop on days when there is no Nigerian news, which is not the case. So I doubt it is very key. In any event, longer term Nigeria has the potential to substantially increase production and their government seems to want to do so, and that could significantly add to global supply of light, sweet crude. So on balance I judge Nigeria to be a neutral factor.

Much more important has been the Saudi announcements that they will hoard their reserves and will not build new capacity beyond the three projects now under way that supposedly will build their capacity to 12.5 mbpd by the end of 2009. With this decision, the Saudi’s are canceling previously announced intentions to build capacity to 15 mbpd. They are also devastating the arguments of the “don’t worry about peak oil” crowd that the Saudis will supply the growth in oil demand projected for future periods.

Oil analysts were virtually aghast at the significance of these Saudi statements. One reason is that KSA is the bell cow of OPEC, and particularly Middle Eastern members. Nobody knows whether the reasons for the Saudi decision was geological or political, but most observers credit it to some of both. To the extent that the Saudis were making a voluntary political decision to hoard their reserves for use by future generations, then that also becomes a strong argument for other countries to do the same thing.

So I credit the new Saudi policy with having a substantial impact on recent oil prices. More significantly, it is clearly more of a long term than short term factor. It will increasingly impact prices as the future unfolds.

One reason the Saudi statements were so dramatic was the prior announcement of Russia’s decline in oil production during Q1 and the sudden recognition by the oil world that Russia may not be capable of increasing oil output at all for the foreseeable future. Russia’s and KSA’s combined news were truly a 1-2 punch to the oil market.

Additional factors influencing oil prices include more evidence of the high cost of new oil production, the recognition that the growing economies of oil producing countries limit the oil they have left over for exporting after domestic use, and finally the growing understanding of peak oil in the popular press. All of these long term oil shortage indications seem to have brought the peak oil concept into respectability among oil traders and would thus seem to be enough to push up the oil price even without a boost from the IEA, which suggested that oil supplies are growing tighter in the short run.

So what is the role of speculators in the oil price run-up? That is impossible to know, of course. But most rapid run ups in a commodity have an element of speculation. This oil price run up has actually been fairly orderly so far, so I suspect speculation has been a factor but not a determinative one in the move from $100 to nearly $120. I look for speculation to be more rampant at some point down the road when the oil price move become more vertical over some short period.

What makes the current price seem a bit speculative in my opinion is that nearly all the causation factors cited above have more impact on the supply and demand for oil in a year, three years, five years out than on today’s market. So it would make more sense to me for oil in 2010 to be moving up faster than oil in June, but that has not been the case. They have actually been move virtually in lock step. The curve is still mostly in backwardization, although it flattens out after late 2010. My belief that the back end of the oil price curve is where the greatest value lies is why the EIS portfolio is leveraged more to the long term price of oil than the short term.

On the other hand, the short term may have one supporting factor that is often forgotten. That is the fact that the “price of oil” which we most often note and discuss is the price for West Texas Intermediate. It is light, sweet crude. It is not the sour polluted stuff that will come from KSA’s new Kharais field or from Venezuela or other places. If you talk to oil geologists about peak oil, they will often admit that light, sweet crude oil has probably reached peak. So, in that sense, perhaps it does make sense that the near term price is rising because it is the price of light, sweet crude, which almost certainly has peaked.

So where do I think the price will go now? As I’ve always said, in the short term anything can happen. There is no way to know. But I would bet it is more likely to be higher a month from now than lower, although I have not made that bet. It seems that the possibility of oil going back down below $100 a barrel is becoming increasingly unlikely. I would bet that in a few years that chance would be virtually zero. In fact that is a bet I have made.

Comments

[otis theimpaler]

The new bid ask will be $105 - $125 until late in the 3rd quarter when real observable world shortages will appear. From there the new bid/ask will be $170 - $220. A year from today oil futures will be > $220.

[AmesTiedeman]

I see $150.00 this year. $250 in 5 years. Demand does not stop until people start walking again.

[flatman]

On the other hand, the global recession could cause oil and commodities in general to drop like a rock as the mo mo guys bail.

[papa]

Jim Hamilton at Econbrowser says to watch the Federal Reserve action due at the end of the month. If the Fed doesn't lower the funds rate, he is (sort of) predicting that oil prices will fall.

[jackknowsAll]

psssstt!! ..u got no clue, like u said..no one knows.and then u claim to know and bet ...dude chill... oil will be under $100 in few months..and i bet ur short on oil instead..

[Investor612]

$150? Likely in the near future. $200? Possible. Above $200? Unlikely. The combination of drivers cutting back and other forms of energy becoming competitive will put a lid on how high oil can go.

[maher]

jackknows..won't take a 'few months' for oil to drop below $100. It will happen in short order/short term. We are in extremely overbought territory now.

Unless, of course, a 'force majeur' occurs, i.e. Israel Syria Iran wars; then all bets are off, and this thing will zoom up to $150 in no time.

[saifl]

I say $1000 in 7 years.
www.financialsense.com...

[chipstaqr]

keep in mind that explosive advances in oil prices are mostly fueled by US-led monetary inflation. natural supply and demand concerns are certainly pushing prices up, but the high drama is courtesy of the federal reserve. see the following chart:

www.rayservers.com/ima...

[fran]

JIM--

whether up or down, when and how much is nice for persons to opine about.

i thank you for the summary of what is happening and the possible consequences. it's helpful for someone not following each happening daily and can get swamped by all buzz

[not lubedand bentover]

we are all screwed, the speculators have manipulated the market by both statements and purposely setting weekly increases of storage or supply to make actuals look much worse than they really are. Where's the data going back 10 years to compare month to month for real averages, I'd bet we are "Normally averaged" based on weather etc...

[flow5]

Break to the downside should be around May 5th.

[Jack Yetiv]

Completely agree with your analysis, Jim. The recent Saudi announcement was truky a shocker to me.

I think the corollary of the announcement is also that if world demand drops and looks like it will take oil back toward $100, Saudi Arabia will CUT production to make sure it does not.

Jack Yetiv

[AmesTiedeman]

Short term pull back as predicted. USO and OIL are shorts.. DUG is a long.