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There are three reasons for the huge spike in the oil price, starting in 2004; they are: 1) the pricing method; 2) type of refining capacity; 3) non-commercial oil futures speculation.

  1. Oil is priced using only two grades of crude: WTI and Brent or the light, sweet crude that is always in high demand. The heavy, sour crude is discounted to the good stuff. Of course, there is less of the sweet crude and more of the sour crude. But the price drop in October 2006 through February 2007, when there was significant, monthly, inventory growth over 2005 on WTI at Cushing, OK, does not indicate robust price support at the margin; the imbalance was corrected in 2007.
  2. There is a heavy, sour crude, refining capacity deficit; if refinery capacity were increased to handle this source, demand pressure would be decreased on WTI or Brent and their price should moderate. But environmentalists don’t want refineries…no one wants them [NIMBY]. As an example, look at the denial of the ConocoPhillips (NYSE:COP) Wood River Refinery expansion in Illinois [Appeal No.07-02]; it was going to handle heavy, Canadian crude. A view of the Environmental Appeals Board work is instructive as to any possibility of future capacity expansion. Couple environmental obstructionism with refinery cost, government refining requirements and the bottleneck on expansion is assured.
  3. Non-commercial, oil futures speculators only add financial pressure to the commodities market. These parties are significantly different from the commodity producers and buyers [hedgers] who trade oil in order to manage the risks of rising or falling prices in their own businesses. They are engaged in price discovery as producers and users of oil. What ‘special knowledge’ would speculators add that commercial hedgers don’t? They add more trading volume, but that was never a problem needing a solution. They do bring a mode of excess; best described by Charles P. Kindleberger in Manias, Panics, and Crashes: A History of Financial Crises. Futures positions can be closed using Exchange For Physicals [EFP] by private negotiation and informing the exchange. While the CFTC prohibits ‘’wash trades,’’ how would they ever know if this method or other tricks were used by world traders to disguise fictitious trades.

Therefore, any measures that help reduce demand for WTI or Brent by increasing the availability of sour crude refining or lessen demand by putting automobile power usage partially on the electric grid, and restrictions on commodity speculators would be helpful.

 

Source: 3 Aspects to Pricing Oil