No Free Lunch
Ready for $200 oil?
By Cielito Habito
Philippine Daily Inquirer
First Posted 18:36:00 05/25/2008
Filed Under: Oil & Gas - Downstream activities
MANILA, Philippines--Lately we've been hearing analysts say that the current levels of world oil prices cannot be explained by the law of supply and demand anymore.
What they really mean is that the supply and demand forces leading to current crude oil prices above $135 are not the normal drivers of supply and demand. The implicit suggestion is that prices are abnormally high and should come down again sooner or later.
I'm not quite sure that will be the case. I'd rather heed Energy Secretary Angelo Reyes' advice to "hope for the best, but prepare for the worst." Most analyses I've seen by oil industry experts seem to point more to the latter, based on a consideration of the array of factors bearing on supply and demand in the petroleum market.
Speculation
A popular explanation lately is that prices are being driven artificially high by excessive speculation in commodity futures markets by hedge funds and institutional investors.
Futures markets are where a commodity can be bought or sold for future delivery (a "futures contract"), with going prices reflecting expectations by market players on future supply and demand.
The problem, the reasoning goes, is that rules on trading in commodity futures allow speculators to buy a crude oil futures contract by having to pay only a small portion (say 6 percent) of the value of the contract.
For example, at a price of $130 a barrel, this means that a futures trader only has to put up only about $8 for every barrel, while borrowing the other $122. This ability to "leverage" commodity futures purchases by up to 16 to 1 helps drive prices to wildly unrealistic levels.
If the expectations of the market players turn out wrong--i.e. future supplies don't turn out to be as tight and/or future demands not as high--prices would sooner or later collapse and the "bubble" would burst.
This follows the same phenomenon as the financial bubbles in Japan real property markets in the 1980s, technology stocks in the 1990s and, most recently, housing and mortgages in the US.
Supply tightening
The crucial question then is, are the expectations that are driving oil prices up to unprecedented levels unwarranted and unrealistic? Are people being too pessimistic about future oil supplies and demands?
One has to take a careful look at real supply and demand factors to answer this. On the supply side, the so-called "peak oil" theory, which holds that remaining world oil reserves will soon be on the downtrend, if not already, has gained many adherents. Supporting this argument is the lack of discoveries of new major oil fields in the last 37 years.
On the opposite side are adherents to the "abiotic oil" theory--those who believe that oil under the ground is being constantly regenerated, and will therefore not run out. The overwhelming view is still that oil is a nonrenewable resource, and that there is a limited amount of fossil fuel in the world.
Increasingly, remaining reserves become more technically difficult, and thus more costly, to extract. Eventually, remaining reserves will only be economically feasible to extract at extremely high prices.
Accelerating demand
Besides long-term supply concerns, labor strikes, limited refinery capacities, hurricane threats to oil platforms, fires and terrorist threats at refineries, and other problems also lead to short-term increases in petroleum product prices.
On the other hand, the remaining accessible supply is being consumed more and more rapidly with each passing year. The demand side outlook is shaped largely by the rapid growth of the giant economies of China and India, along with many other dynamic emerging economies especially in Asia. Recent growth in demand for petroleum comes mostly from these economies, and the growth outlook appears unrelenting in the foreseeable future.
The continuous weakening of the US dollar further feeds the demand frenzy. Because oil is traded in US dollars, there is a tendency to buy more oil sooner than later, when the same dollars would buy less oil. Countries with huge dollar reserves like China would rather convert the asset that is losing value over time to one that is gaining value over time--thereby further reinforcing oil's price climb.
Remove taxes?
These days, I am often asked what we could do in the face of all this. Should we remove or reduce taxes on petroleum? This promises little relief given the level of prices now. I would prefer that government keep the revenues, but use them for targeted assistance to the more vulnerable among us. On the other hand, removing taxes will benefit rich and poor alike, and would again lead to fiscal imbalance and possible macroeconomic instability.
What we can all do is begin to take the necessary longer-term adjustments in our consumption behavior and lifestyles to adjust to higher-cost oil, because to my mind, the world has entered a new era of high oil prices, and things just won't be the same again.
Comments welcome at chabito@ateneo.edu
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