Last May, Goldman Sachs (GS) raised eyebrows on Wall Street by releasing a report warning that crude oil could see a "super spike," with prices reaching as high as $105 per barrel. And now? Well, the price of the front-month crude contract on the New York Mercantile Exchange is averaging above $65 per barrel for the year to date, after hitting an all-time high on Apr. 21 of $75.35. While crude prices have pulled back somewhat since then, it seems the Goldman warning may not be so far from reality after all.
Earlier projections assumed that a serious supply disruption would be necessary to move prices to their current lofty levels. And yet the market price has reached nearly $75 through a combination of factors that have had little effect on overall world supply: geopolitical wrangling about Iran's nuclear program, continued volatility in Iraqi security and output, and a particularly bad spate of militia violence in Nigeria.
In short, the market has reached nearly $75 per barrel without a disastrous supply event. Contrast that with the previous price spike in the second half of last year, driven in part by a very real disruption: the massive dislocation caused by the devastating 2005 U.S. Gulf hurricane season.
The fact that the actual physical supply of oil doesn't seem to matter much in the current price equation is reflected in the loss of OPEC's ability to moderate price behavior. In addition, the price structure for the international benchmark grade of Brent crude oil has taken a curious turn: Prices for forward delivery (i.e., in future months) are higher than for current delivery.
This is unnatural for a traditionally high-volume, low-price commodity that's expensive to store and, again, indicates no shortage of physical crude. Furthermore, crude and oil product inventories in the U.S. and for key industrialized countries remain at healthy levels.
Futures reflect the price of oil decided by demand for a primarily financial contract. There's nothing fundamental to the market in terms of costs of production or return on capital that decides whether the price of oil settles one day at $70, $80, or indeed $100 per barrel. It depends on the amount of money with which market players are willing to back long and short positions.
Given no shortage of crude oil in storage, the only explanation for the current spike is that the physical market's leverage on price has been temporarily suspended, or is being overridden by a futures market driven by a huge influx of capital. These investors are keying on future levels of risk to supply, rather than the immediate supply-demand balance.
While the rise in crude prices, as well as other commodities, has surpassed the expectations of many observers, what has been equally surprising has been the lack of impact of high energy prices on world economic growth. An oil shock of this scope should have caused widespread inflation, resulting in higher interest rates, which in turn would have put a brake on world trade. In previous times, this would have acted as a kind of self-regulating mechanism on demand for crude.
Instead, inflation in both the developed and developing worlds has pretty much been kept under control. Manufacturers have been unable to pass on increased energy prices to consumers and have instead had to accept reduced margins, which have largely been achieved through control of labor costs. This has been helped by the shift in the manufacturing base to countries like China.
In addition, oil prices before the recent rise were historically cheap when adjusted for inflation, which meant that the proportion of consumers' disposable income affected by a rise in oil prices was less significant during the current oil shock than previously.
However, there are signs that any slack there was has now been exhausted. Industries and economies based on raw-material processing will eventually have to pass rising energy costs on to consumers. In the U.S., expectations about average inflation rates have risen from 2.3% in January to 2.8% in May, having already moved up from a low of 1.6% in early 2003. The expected rate of inflation is at the very top of the band with which the Federal Reserve is comfortable.
Consumers' expectations about future inflation are also rising because prices are climbing persistently faster than officially announced rates of inflation. Official price indices strip out energy costs and make other adjustments that mean measured inflation is lower than the cost-of-living increase experienced by families. When energy prices rise quickly, that anomaly becomes more readily apparent and begins to shape expectations about future inflation.
On the fundamental side, there are two key processes under way that could influence prices: the rebuilding of surplus crude capacity and the gradual slowing of demand growth. The latter could come not only as consumers switch to other fuel sources but also potentially from slowing world economic growth as a consequence of any greater-than-expected monetary tightening by central banks to rein in inflation. These are slow processes and will evolve over a two- to five-year time period in which physical-world crude markets will stay in a delicate balance.
During the next few years, prices will remain exposed to any disruption to supply, while price volatility will be magnified as the relationship of price movements in futures markets to actual supply conditions in physical markets has become increasingly elastic and erratic. In short, the price of oil will be subject to some daunting wild cards -- not only in terms of the geopolitical situation, but also the changing dynamics of the futures markets. As a result, the prospect of $100 oil is no longer a fantastical pronouncement -- it's a real possibility.