Politics of oil about as murky as the skies over Beijing

The price of oil is falling, which many people find soothing. They shouldn't. Turn on the television next weekend, tune in to the Olympic games and it will become evident why.

The price of oil is falling, which many people find soothing. They shouldn't. Turn on the television next weekend, tune in to the Olympic games and it will become evident why. Barring some meteorological miracle, the skies over Beijing are going to be murky with smog, evidence of the true cost of China's rising prosperity and its growing addiction to oil. Addiction is the right word for it, because it helps to explain why the price of oil moves the way it does. Like any drug, oil is priced best when it is as high as possible without slipping beyond the addicts' ability to pay for it. Price it too low, the customer overdoses and dies. Price it too high and he heads for rehab and kicks the habit, installs solar panels on his house and starts filling his tank with jatropha, a form of vegetable oil.

Talk to oil experts long enough and it dawns on you that oil prices are less about supply and demand than about maximising the long-term profitability from the somewhat inflexible yield on some very expensive and very deep holes in the ground. While the West may whine about the need to turn up the taps from the oil wells, producers are staring down their drill bits at a limited resource which has an optimal production rate that needs to last for as long as it can. Conversely, it's hard to imagine a world with more oil than it wants. Oil is one of those products people can never get enough of. Honestly, who can wake up in the morning and say they could do with a little less energy?

Is there a natural price for oil, then, one that reflects the true supply and demand? I asked Edward Morse, the oil economist at Lehman Brothers in New York, this question recently as oil looked set to hit $150 a barrel. His answer: about $80 a barrel. The rest of the price was inflated by a number of factors, he said, none of them having anything to do with relative demand or supply. Some of the price inflation is the result of speculators, the kind of investors that the US Congress recently tried to demonise. Most of these investors, Mr Morse said, are technical traders who use mathematical models to predict price movements. Mr Morse works in proximity with some of them, and he knows that at certain junctures in the price movement of any commodity, the technical traders start to move in because their models tell them to. This accounted for roughly $10 of oil's peak price.

Another $20 of the price, he said, was a reaction to the declining US dollar. Oil is priced in dollars, of course, so as the dollar has declined against other currencies in response to the US financial crisis, commodities like oil have risen in dollar terms. Of course, as the dollar declines, investors try to avoid losses on their dollar holdings by buying commodities such as gold and oil, which helps push the price up even faster. Another $10 comes from the fact that most of the hedging in oil markets is by buyers rather than sellers. Buyers, like airlines, tend to buy oil contracts to hedge against the risk that fuel prices will rise later when they need it. Such purchases have a self-fulfilling phenomenon, helping to push prices up.

In most markets, like agricultural products, this upwards pressure would be offset somewhat by the purchase of oil contracts by producers hedging against the risk that prices might fall. But oil producers generally never buy oil puts, Mr Morse said. If prices fall, they can defend prices simply by curtailing sales. Oil, after all, doesn't go bad in the barrel. Yet another $10 comes from the risk that oil supplies could be hit by unforeseen factors, such as hurricanes in the Gulf of Mexico, or a decision by President Bush to attack Iran.

And the last $15 is the result of the fact that oil markets are about as murky as the skies over Beijing. While the developed economies of the West, Japan and South Korea pay careful attention to oil imports, inventories and consumption, in the rest of the world how much oil is being shipped here and burnt there is really anyone's guess. Saudi Arabia, for instance, releases figures on production, but not exports. China's own trade statistics are notoriously unreliable. Many traders, therefore, extrapolate from trends in the West to predict global oil prices, and were until recently betting that inventories were running low. On the contrary, Mr Morse said, global inventories were growing, part of what he called a "stealth supply" of oil as countries quietly built their own reserves.

So why are prices falling? Because after rising for so long, the addicts finally gave in. With petrol prices rising above $4.10 a gallon and the economy sputtering, Americans are driving less and switching to more fuel-efficient cars. In May, they drove 10 million fewer miles than the year before. And oil prices are responding: they've dropped more than 16 per cent this month, part of a broad retreat by commodities as traders realise prices had overshot the willingness of the addicts to pay.

The problem is that Americans are just driving less, not abandoning their cars and demanding decent mass-transit systems. Now petrol prices are falling - not as fast as oil, but enough that the suburban lifestyle may still look feasible. Indeed, oil prices only need to fall back to what was a record a few months ago to derail the kind of momentum for political change supported by politicians like Barack Obama. High oil prices, painful as they may be, are catalysing the kind of changes to the American consumer lifestyle that are so necessary to ending the cycle of oil addiction and indebtedness that has thrown the world into its worst financial crisis since the Great Depression.

At the receiving end of this tidal shift in global wealth, in China and India, high oil prices are slowly crushing a system of state subsidies that encourages wasteful development and instead are forcing governments and companies to devise cleaner avenues to growth than the pollution-ridden example set by the West. And here in the Middle East, high oil prices are fuelling a renaissance that is helping the region finally escape the tyranny of oil. But it is a renaissance that has so far failed to significantly shift the economy from the state to the private sector. Lower oil prices would probably raise the political pressure, but it is doubtful that they would produce a more desirable outcome.


Published: July 30, 2008 04:00 AM


Editor's Picks
Sign up to:

* Please select one

Most Read