Boiling Point: background on oil prices

Straits Times 29 Jun 08;

To most consumers, oil prices just seem to have gone crazy. The price of crude oil has risen more than fourfold since 2004 and shot up over 120 per cent this year alone. Last Thursday, after fluctuating wildly for a few weeks, it hit a new high of US$140.39 (S$191) a barrel.

Traders of oil futures on the New York Mercantile Exchange are now betting that oil prices will remain at about US$120 a barrel for at least eight years. How did this come about? Yang Huiwen looks at the changing forces of supply and demand for oil, and the dangerous new role that speculators are playing in determining the price of one of the world's most precious assets.

DWINDLING SUPPLY

Who produces the world's oil?

There are two types of oil producers in the world - Opec producers and non-Opec producers.

Opec producers:

# The Organisation of Petroleum Exporting Countries (Opec) is a group of 12 countries that have formed a cartel. This means that they do not compete with one another to supply oil. Instead, they meet regularly to set the price of oil for the world market.

# The 12 Opec countries are Saudi Arabia, Iran, the United Arab Emirates, Kuwait, Venezuela, Nigeria, Angola, Libya, Iraq, Algeria, Qatar and Ecuador.

# Opec currently produces about 36 per cent of the world's oil.

# Estimates are that Opec actually has two-thirds of the world's oil reserves.

But actual reserve levels in key Opec players such as Saudi Arabia, Iran and Kuwait remain hazy due to a lack of transparency.

Non-Opec producers:

# The key non-Opec producers are Russia, Brazil, Kazakhstan and Mexico. Russia is the second-biggest oil exporter after Saudi Arabia.

# Together, the non-Opec producers account for the remaining one-third of the world's oil reserves.

But production numbers from some non-Opec countries such as Norway, Britain, Pakistan and Mexico have been flat over the past decade and have even begun to decline.

Who decides how many barrels of oil to supply to the world market, and how are prices set?

Opec adjusts the supply of oil to closely match the world's demand. This stabilises oil prices at a level which is favourable to its member countries.

# Opec production fell by 390,000 barrels per day in April due to supply disruptions in member states Nigeria and Iraq.

# Saudi Arabia, the world's biggest oil exporter and de facto leader of Opec, will raise production by 2 per cent, or 300,000 barrels a day, from next month to curb skyrocketing oil prices.

# Through regulating the supply of oil, Opec indirectly sets the price per barrel. Restricting supply will cause prices to go up, assuming demand doesn't change, and vice versa.

# Non-Opec countries are like free traders of the oil market as they are not bound by any supply controls. High oil prices give them the incentive to maximise production but that results in a faster depletion of oil reserves.

What are the current issues surrounding oil supply?

One key issue that has dogged the industry is supply disruptions in oil-producing countries such as Nigeria, Ethiopia and Iraq due to social unrest.

In particular, Nigerian rebels have been damaging key supply pipelines of oil companies in a campaign to get a bigger share of oil revenue.

# Opec has been reluctant to increase production, maintaining that the world currently has enough oil supply to meet demand. It has blamed high oil prices on speculators.

# With limited production capacity from non-Opec countries, the world will have to be increasingly dependent on Opec for oil production. But there are serious doubts about Opec's ability to meet such production shortfalls in the future as there is a lack of transparency regarding their actual reserves.


RISING DEMAND

How much oil is consumed and who are the world's biggest oil guzzlers?

World oil use will climb by 1.2 million barrels a day this year to 87.2 million barrels a day as demand increases in emerging markets such as China and India, according to estimates given by the International Energy Agency (IEA).

# Total world oil production is averaging at about 87 million barrels per day so far this year, slightly higher than the average of 85 million barrels a day in 2006.

# The United States is the world's largest oil consumer, followed by China, Japan, Germany, Russia and India.

The US, the world's largest economy, guzzles 20.73 million barrels of oil per day, more than the combined consumption of the next five economic powers.

How fast is demand rising for oil?

# Demand is forecast to grow 50 per cent over the next 20 years, with the bulk of the demand coming from developing countries, according to the US Energy Information Administration.

# Crude oil is refined into other products, including petrol and kerosene (jet fuel) which are used in the transportation industry. Naptha and ethane are used as feedstocks in the production of petrochemicals such as plastics and rubber.

# Other useful products which are not fuels are also manufactured by refining crude oil, such as lubricants for machinery, and asphalt, which is used in paving roads.


RAMPANT SPECULATION

Who are the oil speculators?

# The boom in oil prices has brought speculators out in full force, and they are not digging in the dirt looking for black gold.

Rather, speculators profit from big rises and falls in the price of any commodity, including oil.

# The speculation occurs mainly in the oil futures market, which has traditionally been used mainly by buyers and sellers of oil (mainly oil producers and energy-related companies) to hedge price risk.

# But now, a group of new players - including investment banks, pension funds and hedge funds - has become the largest players on the main crude oil futures exchanges, especially the New York Mercantile Exchange.

# hanks to the dramatic price rise, investors are also pouring money into commodities, including oil.

Many investments are made through structured investment products offered by financial institutions that aim to provide investors a hedge against inflation, which is high, and a weak US dollar.

This inflow of money into commodities is further driving up prices.

To what extent have they affected oil prices?

Speculators now control 71 per cent of contracts to buy West Texas Intermediate crude oil on the New York Mercantile Exchange, compared to just 37 per cent in 2000, according to data provided to the House Energy and Commerce Committee by the Commodity Futures Trading Commission.

# Trading activity by speculators has caused much uncertainty and increased volatility in oil prices.

The main concern is that oil prices are being determined by speculative money and are no longer a true reflection of underlying supply and demand fundamentals. This makes price changes sentiment-driven, and even harder to predict.

What is being done about them?

# Politicians in the US and Europe have called for curbs on speculators, whom they blame for high prices.

# The US Democratic Party has suggested tightening restrictions on pension funds and investment banks by imposing higher margin requirements for oil-related trading. About a dozen Bills are pending in the US Congress to rein in excessive speculation in the energy futures markets.