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Unforeseen events playing havoc with oil prices

WASHINGTON—When a tropical depression in the Caribbean was upgraded to Tropical Storm Dennis this week, crude oil prices immediately began climbing on the New York Mercantile Exchange.

Traders feared that at least one of the four tropical depressions off the U.S. Atlantic and Gulf coasts could become a hurricane that would delay oil deliveries, damage offshore oil rigs and threaten onshore refineries. That means temporary oil shortages are possible, a fear that drives up fuel prices.

Volatile oil prices look as if they're here to stay, experts agree, at least for a year or two. Why? Partly because world oil demand is growing faster than oil production. Partly because financial speculators are gaming the markets. And partly because nobody knows just how much oil is available, not least because it's unclear just how much oil Saudi Arabia has.

It is clear that the growing appetite for oil in China, India and other emerging economies has reduced the world's margin of extra oil-production capacity. The world now consumes about 84 million barrels of oil per day. If every well in the world is producing flat out, analysts said, total production could equal no more than 86 million barrels a day.

That small margin of extra capacity isn't much of a cushion against unforeseen events such as a terrorist attack, refinery fire, pipeline rupture or a natural disaster such as last September's Hurricane Ivan, which damaged oil rigs and platforms and removed about half a million barrels a day from the U.S. market for months.

That's why markets are nervous and fuel prices are high. Right now, U.S. oil inventories are near all-time highs, so there's no supply shortage here. But if anything cuts oil production anywhere in the world, there could be a shortage, very soon.

"Clearly, we are in a situation where the likelihood of us entering a supply-tightness scenario has increased, and that's what this market is playing off—that fear of what could happen," said Kyle Cooper, an oil analyst with Citigroup Inc. in Houston. "Fear and psychology are major market factors."

Crude oil prices closed at $61.28 a barrel Wednesday, the highest price since oil began trading in 1983 on the New York Mercantile Exchange. But when adjusted for inflation, today's prices remain well below those of the 1980 oil crisis, when oil reached more than $90 a barrel in today's dollars.

Goldman Sachs & Co. warned earlier this year that supply disruptions could lead crude oil prices to surge above $100 a barrel. At those prices, demand for oil would fall sharply, leading in time to excess supplies and eventually a collapse in prices.

Merrill Lynch doesn't think prices have to go that high before they collapse. The investment powerhouse thinks today's high prices already are dampening global demand and that prices ought to be able to fall back to about $42 a barrel by next year. That would put gasoline prices back under $2 a gallon for Americans.

Cambridge Energy Research Associations, a consulting firm, thinks today's high prices will lead to enough investment to boost global oil-production significantly, perhaps as much as 20 percent by 2010. That would outpace the growth of oil consumption and lead to falling prices, the firm said.

The investment-production cycle takes time, however, and it isn't likely that much new oil production will come before 2007, the firm reckons.

"We generally expect supply to further outpace demand growth in the next few years, which could result in oil price weakness around 2007-2008 or thereafter," a private report by the firm said in June.

In the meantime, expect volatile prices, partly because speculators are gaming the market. With surging demand for oil and additional production still years from reaching market, conditions are rife for financial speculation.

The price of oil is set in markets, where traders buy contracts, called "futures," for deliveries of oil at a future date. Some of today's heavy trading in futures reflects industrial users buying oil now at a set price to protect themselves in case prices have risen even higher when they need the oil.

Other oil-futures contracts are being bought by speculators such as hedge funds that have no intention of taking delivery of the oil. They bid up the price of futures contracts, then sell them to take profits. This explains some of today's volatility. How much of today's futures' buying stems from speculation is impossible to quantify, but experts said it was having a significant impact on prices.

"Current oil prices are basically where they are because about half of the people following oil are sure the prices are going to collapse. And the other half are actually trying to make sure they have enough oil to get through the summer," said Matthew Simmons, who runs a Houston investment bank specializing in the oil industry. "If you had 9 out of 10 people who thought we're going to have a problem, oil prices would be way higher than they are today."

Simmons is one who thinks we're going to have a problem. His new book, "Twilight in the Desert," asserts that oil production in Saudi Arabia has reached or is near peak production.

If that's true, the remaining oil there would be harder and costlier to pump out. Once that point comes, Saudi Arabia—home to an estimated one-quarter of the world's oil reserves—would begin a downward slide in annual production that could drag down the global economy.

"I keep saying that if people knew anything about how real the situation is, the fear factor would drive the price (of oil) way higher," Simmons said in an interview.

To calm fears provoked by Simmons' book, Khalid al Falih, a senior vice president for the Saudi state oil company Aramco, came to Washington on June 27 to assure that all is well in the Saudi oil industry.

"We have in these reserves over 100 years at current production," al Falih told a standing-room-only audience at the Center for Strategic and International Studies, a conservative research center.

Saudi Arabia, he said, has depleted only 28 percent of its reserves. It will add 3.1 million barrels of new daily production over the next five years. As some existing wells decline, on net that will boost today's daily capacity by about 1.5 million barrels, to more than 12 million barrels. If needed, he said, Saudi Arabia could produce up to 15 million barrels per day within a few more years.

That sounds great if you take the Saudi government at its word. Little independent auditing of oil reserves is done, and few experts think that existing production and delivery numbers are accurate.

"To give confidence and comfort in the marketplace, we need to have more reliable supply and demand figures," said Frank Verrastro, the Center for Strategic and International Studies' director of energy programs.

Simmons, who's controversial for asserting that the Saudi government has overstated its reserves, calls for independent auditing, believing that it could quantify a resource that's the lifeblood of the world economy.

"I don't think that would be appropriate or necessary," al Falih told Knight Ridder.

Gene Sperling, who served as President Clinton's top economic adviser from 1997 to 2001, said oil statistics perplexed him.

"Not many people can say with precision exactly how much excess capacity Saudi Arabia has at a particular time. And the market's expectation of how much they have and how much they are willing to use can be very consequential," Sperling said. "Even when you have the top experts around projecting what is the precise level of excess capacity at a given moment, it hit me that it usually involved very educated guesses, as opposed to the type of precision you might have expected."

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(c) 2005, Knight Ridder/Tribune Information Services.

GRAPHIC (from KRT Graphics, 202-383-6064): Oil prices

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