Why Is Oil So Expensive Again?

More demand and fears of Mideast extremism are two reasons, but prices could ease soon

It wasn't supposed to be this way. As recently as last summer, many experts were predicting that by now oil prices would have fallen into the mid-$20s per barrel. After all, the U.S. invasion of Iraq didn't destabilize the Middle East, as some feared, and Saddam Hussein didn't set Iraq's oil fields ablaze.

Yet oil is nearly as expensive as it was on the eve of the Iraq war, when prices hit a 13-year high of $38 a barrel. Indeed, since Dec. 1, prices have risen 13%, to more than $33, after briefly touching $36. Gasoline, too, has soared. Prices averaged just over $1.66 a gallon at the end of January, up 15 cents from mid-December, to the highest ever for a winter month. Says Fadel Gheit, an oil-company analyst at Oppenheimer & Co.: "If someone had told me six months ago that we would enter 2004 with oil at $34," he says, "I would have said you must be smoking something."

What's going on? Last year's fears have been replaced by a new set of worries: Islamic extremism will destabilize Saudi Arabia, which owns the world's biggest oil deposits. The amount of proved reserves held by Western oil companies will shrink as others follow Royal Dutch/Shell Group's (RD ) lead in restating numbers. And -- the most common worry -- rapid growth in China and the U.S. is exceeding oil supplies.

Phil Flynn, senior energy analyst at Chicago-based Alaron Trading Corp., thinks crude oil will hit $40 a barrel this year. Says Flynn: "More demand for oil will cause prices to go up. It's as simple as that."

GROWING SUPPLIES. Are the doomsayers right? Don't bet on it. Oil is already down $3 from its Jan. 20 peak of $36.20 on the New York Mercantile Exchange, and there are reasons to expect a further slide. Whatever the long-term outlook for the Saudi royal family, right now it's in charge -- and guiding prices down. Shell's restatement of reserves doesn't reduce how much oil is actually in the ground, and neither would other companies' restatements.

And while stronger global growth is boosting oil demand, supply is increasing, too, because high prices are triggering more exploration and production. Add it all up, and there's a good chance that prices will average below $30 this year. "Prices at these levels are unsustainable," argues John P. Kilduff, senior vice-president of commodity trader Fimat USA Inc. in New York.

Who's right matters, because costly oil hurts the economy by driving up prices of everything from gasoline, diesel, and home heating oil to jet fuel and petrochemicals. On the other hand, a drop in oil could give a boost to the recovery. If oil averages $28 a barrel this year instead of $33, it could add nearly a half percentage point to growth, says Mark M. Zandi, chief economist of Economy.com Inc.

BETTING ON A FALL. For the moment, though, oil prices are higher than almost anyone expected. Long-term fears about imbalances in the oil market have been compounded by other factors. For one, the U.S. continues to sock away oil in the Strategic Petroleum Reserve, subtracting it from the consumable supply. While the Energy Dept. says the additions haven't affected oil prices, estimates of the impact by outsiders range from 60 cents to $6 a barrel.

Globally, labor unrest and conflict in such key oil states as Venezuela, Nigeria, and Indonesia have impaired crude production. And there are signs that the fall of the dollar against the euro, yen, and other currencies has increased OPEC's desire for a higher dollar price for its oil.

The good news is that oil supplies seem to be keeping up with demand -- and that should help bring down prices. While U.S. inventories are at their lowest levels since 1975, there is scant evidence of a worldwide shortage. A prime topic at the Feb. 10 meeting of OPEC ministers will be their fear that a glut of oil could pressure prices in coming months. Traders on the New York Merc are betting that crude prices will drop another $3 a barrel by August. And in a switch from the usual pattern, the August futures price of wholesale gasoline is 4 cents lower than the February price -- reducing the likelihood of a big surge in pump prices during the summer driving season.

Behind the supply increase is the fact that prices have stayed high long enough to encourage more production. Citing a pickup in drilling by its customers, Schlumberger Ltd. (SLB ), the world's largest oil-services firm, reported a 48% increase in pretax operating income on a 12% revenue gain in the fourth quarter.

The increased activity is broad-based, and has been in the works for the past couple of years. Worldwide exploration-and-production budgets of 335 oil and gas companies for 2004 are up 4% from actual spending in 2003 and up a respectable 14% from 2002, according to James D. Crandell of Lehman Brothers Inc. (LEH ). As usual, the quickest to react are smaller companies that invest in smaller, cheaper projects. Crandell says Houston-based Noble Energy Inc. (NBL ) is raising its exploration-and-production budget 21% this year, to $278 million, while Unocal Corp. (UCL ) is boosting its budget 13%, to $700 million.

SLOW WORLDWIDE GROWTH. Along with oil prices, oil stocks have risen sharply since the end of November. While the Standard & Poor's 500-stock index is up 8% over the period, its oil-field services index is up 29%. In another sign of life, initial public offerings of energy stocks have returned to the market. Transocean, a Houston-based drilling company, plans to sell 20% of its TODCO unit, which operates in the Gulf of Mexico, in an offering that values the unit at $700 million to $800 million.

At the same time that supply is growing, the increase in demand isn't as marked as many assume. Yes, oil consumption has been increasing 6% a year in China. And the unexpected surge of growth in the world's biggest consumer of oil, the U.S. -- which expanded at an unsustainable rate of more than 8% in the third quarter -- has pumped up demand.

But many other nations have kept usage flat or falling because of slow growth, a switch to other fuels, and better efficiency. The bottom line? The Energy Dept. says that world growth in petroleum consumption has averaged just 1.5% a year since 1995, despite China's growth.

As the last year shows, being optimistic about oil prices is a risky business. Terrorism could still destabilize the oil-rich Middle East. Or a strong, synchronized global recovery could cause oil demand to race ahead of supply, at least temporarily. On the whole, though, the likelihood is that prices are headed down from here, not up.

By Peter Coy in New York and Stephanie Anderson Forest in Dallas, with Stanley Reed in London

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