Peak Oil News: Cheap oil is history. But why?

Wednesday, May 28, 2008

Cheap oil is history. But why?

Telegraph



By Dan Roberts


100 years after oil was found in the Middle East, prices are at $135 a barrel. What’s driving the surge? Dan Roberts reports .

The smell of sulphur was, by all accounts, overwhelming. One hundred years ago this weekend, the British explorer George Reynolds made the first big discovery of oil in the Middle East.

Shortly before dawn on the morning of May 26 1908, it came gushing out of the sands of Persia in quantities that would transform not just the region’s fortunes but the entire world.

A century on, the global gushing noise is being replaced with something else. There’s plenty of the black stuff still down there, but it sounds more like someone slurping at a straw, poking around the bottom of a glass in among the ice cubes.

The company Mr Reynolds worked for is now called BP and its newest rig, Thunder Horse, has to drill through three miles of mud, rock and salt, topped by a mile of ocean, to get to the latest finds in the Gulf of Mexico. The days of easy oil are over.

You need go no further than the local petrol station to see the difference: suddenly, filling a family car costs £70. The price of crude has doubled in 11 months, rising 8 per cent just this week to $135 a barrel. Analysts predict it could reach $200 by next year.

The effects are everywhere. Soaring fuel bills for airlines threaten cheap travel and long-haul tourism. Politicians from Crewe to North Carolina are taking a drubbing from voters worried about the rising cost of living. Economists and stock market investors alike look to oil prices for their sense of direction: so far, it’s all one way.

The stampede in the oil market is making billions of dollars for a lucky few and leading others to wonder whether the world is finally starting to run dry. Until recently, the notion that international production was about to reach its limits – the so-called “peak oil” theory – was the preserve of cranks and crackpots.

The orthodoxy was that we had decades of growth left to come. Now peak oil conspiracy theories are passing into the mainstream. Even the prestigious International Energy Agency is preparing to slash its estimate of how much oil is left.

A gradual decline in global production might last for decades, but the laws of supply and demand move much faster: as the giant economies of China and India demand ever more energy, the pessimists claim only a dramatic change in our lifestyles will avoid further skyrocketing oil prices.

“Eighty-five million barrels of oil a day is all the world can produce, and the demand is 87 million,” says T Boone Pickens, a US hedge fund trader specialising in oil. “It’s just that simple.”

But the facts are not that simple. Just as the theory of peak oil is gaining ground in the trading rooms of London and New York, other conspiracy theorists are winning over politicians and commentators with a rival explanation for soaring prices.

They point to anomalies in the oil market, which mean there are actually surpluses building up. Iran has 25 million barrels of excess crude floating around in storage ships.

“There are simply no buyers because the market has more than enough oil,” says its Opec representative, Hussein Kazempour Ardebili. The oil cartel’s estimates are almost the opposite of Wall Street’s: 88.75 million barrels a day of supply and 86.8 million barrels a day of demand.

So why the record prices? The controversial theory is that the traders themselves are to blame. By speculating on ever higher prices, they are ensuring that they come about. Ordinarily, such arguments would be dismissed as economic illiteracy. Most economic studies maintain it is just not possible to influence the market in this way.

But the changing role of investors has attracted attention at the highest level. Last

week, the US Senate held hearings into whether excess speculation was to blame for high commodity prices. Billions of dollars of pension fund money and other institutional investment is indeed pouring into the commodity markets in a way it never used to.

Michael Masters, a hedge fund manager who is critical of his industry’s role, estimates that the amount of money invested in commodity index-tracking funds had risen from $13 billion in 2003 to $260 billion by this March.

“Individually, these participants are not acting with malicious intent; collectively, however, their impact reaches into the wallets of every consumer,” he warns. Critics call this “virtual hoarding” and point to the surplus of current supply as evidence that the futures market has become separated from the fundamentals of supply and demand.

Whether this is indeed the case depends, sadly, on who you ask. “Traders can rarely see beyond their own trade, and they usually come up with whatever explanation flatters their own position,” says one experienced market watcher in London.

“There is an awful lot of self-interest when it comes to this issue.” Opec has blamed speculators for high oil prices almost since its inception.

Privately, many “speculators” are unrepentant – often almost gung-ho about the wild markets. “I can tell you that I have made a fortune in the past two months,” says Charles, an oil futures trader. “This is the free market and I’m exploiting the free market. Long live the free market.”

Others caution that the real money is being made by oil producers – mainly the state-owned companies in places like Saudi Arabia – rather than middlemen. “Some traders are making money, but plenty more are losing it too,” adds the London market veteran.

“The swings are so huge that you only have to get your European gasoline position slightly wrong, for example, and you can kill the fund with hundreds of thousands of dollars of losses.”

Some of the biggest money has been made by the investment banks, who act for hedge fund investors and are allowed special exemptions from rules governing the size of speculative commodity investments. It is no surprise to find that some of the biggest supporters of rising oil prices work in the research departments of such banks.

Arjun Murti of Goldman Sachs is typical of this more sanguine breed, but at least he has form for getting it right. Last year he shot to fame by correctly predicting the “super spike” that would take oil prices to $100. Now he sees a real chance of $200 in six months to two years.

“Opec’s spare capacity remains at very low levels,” he says. “Saudi Arabia is starting to acknowledge that production is not going to grow infinitely into the future.”

Mr Murti also warns against looking for scapegoats. “The energy crisis will not be solved by punishing the big, bad speculator,” he says.

“The fact that tight oil [markets] are attracting large amounts of capital is a good thing. Higher oil prices signal to oil companies the need for greater investment and signal to consumers that they need to demand less. This is the point of capitalism.”

Don’t shoot the messenger, in other words.

If ever the oil realists needed a sign of how the world’s balance of power has shifted, it came last weekend when President George Bush returned empty-handed from a mission to Saudi Arabia. He had hoped to persuade this key Opec producer to turn up the taps and help the struggling US economy recover from the credit crisis. He got a rather derisory promise of 300,000 extra barrels a day, which experts claim was largely being pumped already.

“The Saudis knew what they were doing,” says one London oil executive. “An extra 300,000 barrels a day is neither here nor there, but if they added a million a day the oil price would react instantaneously: you could see prices back at $50 a barrel within a week or two. Why would they want to do that?”

Among the major Western oil companies, the view is equally simplistic: the problem is supply, not demand. Twenty-five years of underinvestment means the oil companies in countries like Iran and Saudi Arabia are not capable of fully exploiting their reserves.

The majors’ big new finds in the deep-water Gulf of Mexico, off the coasts of Africa and Brazil, and in Russian Arctic cannot compensate for slow production growth in the Middle East. Of course, when you translate this argument to compensate for special interest, you get a plea to be allowed back into countries like Iran, which threw out the Westerners all those years ago.

So if everyone is “talking their book” – that is, arguing the case their commercial interest dictates – who is really to blame for higher prices? Perhaps the most sensible conclusion is that many factors are at play: maturing oil fields; rising demand from India and China; a wall of speculative money; Opec’s cartel; underinvestment in new wells; and a falling US dollar exchange rate.

An equally sensible conclusion is to forget why and how, and focus on the implications of dearer oil. Given how little Gordon Brown, for example, can do about the price of oil, he might be better to focus on cuts in fuel duty. Or perhaps we should join Goldman Sachs in celebrating the effective functioning of market price signals: the market is telling us to consume less oil, so let’s start at home.

One of the biggest grounds for optimism, especially for those worried about carbon dioxide emissions, is that costly oil is good for the environment. The US is already changing its ways. The oil community was shocked to see that gasoline consumption fell this winter in response to higher prices. As the credit crunch bites, it seems Americans are prepared to wean themselves away from gas-guzzlers in favour of smaller vehicles.

The other good news for Britain is that oil is something we are good at. It’s not simply BP and Shell: the stock market is teeming with new oil and gas exploration companies that sell their expertise around the world.

Britain’s North Sea is also seeing its life extended by high prices, as more marginal fields become profitable again. And the UK economy is less energy-dependent than many, thanks to its bias in favour of services rather than manufacturing.

None of this changes the fact that soaring oil prices threaten to change our way of life as fundamentally as the discovery of all that cheap energy did a century ago. Almost ever since, the world has been shrinking as falling transport costs bring us steadily closer together.

In future, air travel may once again become a luxury. If we don’t find other ways to live our lives, we may simply be priced out of the market for oil by the determination of new global consumers to use what’s left.

One of the most respected historians of the oil age, Dan Yergin of Cambridge Energy Research, predicts an imminent “breaking point” when changes in behaviour and use of alternative energy sources start to drive down the oil price again. Put simply: “Very high oil prices will change the world.”


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