With oil flirting with $100 (Rs3,930) a barrel, there seems to be no stopping the dizzying ascent of the black gold. In such a frothy market, it may seem old-fashioned to talk about supply and demand. But they and other fundamentals give a clear message: The price is too high to be sustainable. There are 10 solid reasons why:
1) Supply above ground is abundant. The amount of oil in storage tanks around the world is near all-time highs—4.2 billion barrels at the end of June in the industrialized countries of the Organization for Economic Cooperation and Development alone, according to the US Energy Information Administration (EIA). Falling inventories in the US has received a lot of attention, and the EIA does predict slightly lower stocks by year end. But this has more to do with inventory management than a lack of supply.
2) Supply below ground is abundant. The world’s proven reserves are now at 1.4 trillion barrels—up 12% in the past 10 years, according to BP Plc. That’s not even counting the estimated 1.7 trillion barrels of oil locked in Venezuela’s Orinoco tar sands. Combined, that comes to a century of production at the current rate.
3) Production is set to increase. Sustained high oil prices have encouraged drilling. There are 45% more oil rigs in service today than there were three years ago. New rigs are more productive than old ones and new technology is helping to squeeze more oil out of old fields.
4) The cost of production is much less than $100 a barrel. Even with oil-services costs soaring, Shell’s lifting cost per barrel of oil equivalent in 2006 was about $9, according to energy research firm John S. Herold Inc. Extracting oil costs Saudi Aramco, the Saudi Arabian producer, an estimated $4 to $5 a barrel. The full cost of new production, including both capital and operating cost components, in the most challenging oil fields, for example in Canada’s oil sands, is perhaps $30 a barrel. Oil prices can fall heavily without making any of this production uneconomic.
5) Iranian exports aren’t likely to be cut. The US is in practice unlikely to take military action against an adversary three times the size of Iraq. And with oil exports accounting for 50% of Iran’s gross domestic product and 90% of its hard currency earnings, a self-imposed cut in exports would be self-destructive.
In any event, the world has the equivalent of nearly three years of Iranian production in storage, according to research from Oppenheimer & Co. Inc. This risk shouldn’t be a big factor in oil prices.
6) High prices are pulling back demand. Oil consumption in the US fell by 1.3% in 2006 and worldwide demand grew a measly 0.6%, according to BP.
Worldwide, demand this year is expected to be flat compared with last year. ExxonMobil Corp. cut its long-term forecast for oil consumption growth this week.
7) High prices are forcing governments to cut subsidies. Iran is rationing gasoline, and last week China ordered a 10% increase in oil product prices. That should curb demand growth, too.
8) Oil is too high relative to other fuels. Oil, by the barrel, has usually traded at six to 10 times the price of natural gas (measured per million British thermal units). It’s currently at 13 times.
9) The weak dollar is a poor excuse for high oil prices. Since 22 August, the dollar is down by only 8% against a basket of currencies, while the oil price has risen by 40%.
10) Speculation is artificially boosting prices. A speculator needs to put down only $4 per barrel as margin to bet on the oil price in futures markets.
The net volume of open crude oil contracts held by financial players is up 50% since August, when the credit crunch made it harder to make leveraged bets in some other markets. This looks like short-term, hot money.