Oil Prices Could Get Even Worse

With surging demand and troubles from Russia to Iraq and Venezuela, we could see $50-plus prices. Hope for a mild winter

By Stanley Reed

When will the world get a break from oil prices that seemed unimaginable a few years ago? Not anytime soon, analysts believe. If anything, the upward march seems to be gaining momentum, with U.S. oil prices breaking through $44 a barrel on the New York Mercantile Exchange this week. Paul Horsnell, head of Energy Research at Barclays Capital in London, now says: "The question is not whether $50 [per barrel] will be breached," but whether there will be any pause before the half-century mark is topped.

While there are lots of conspiracy theories about $40-plus barrel prices, a look at the fundamentals goes a long way toward explaining the hike. Growth in demand this year has proved a lot stronger than anyone forecast. The International Energy Agency, the Paris-based consumer group, forecasts that demand will be increase by as much as 2.5 million barrels a day over last year -- about double the increase anticipated.


  Indeed, the spurt in demand from China, the U.S., India, and elsewhere has caught just about everyone unawares. Governments, most notably the U.S., have done little to encourage conservation.The entire industry -- from OPEC to the international oil companies -- have failed to invest sufficiently in production capacity. Such investments will gradually increase, but it will be years before the effect is felt. As a result, spare production capacity is only about 1 million barrels per day, vs. 6 million barrels per day two years ago, Horsnell reckons. That razor-thin margin has the markets worried about the possibility of a severe crunch, especially when seasonal demand picks up. With the system already under strain, a cold winter in North America could have severe consequences.

There are also geopolitical situations weighing on the markets. Saudi Arabia, the world's most important oil exporter, is fighting Islamic insurgents who have targeted oil workers. Venezuela, another key producer, is seething with political unrest in the leadup to the Aug. 15 recall referendum on President Hugo Chavez. Russia, which not long ago was the best hope for stable new supplies, is now also a question mark thanks to the Kremlin's decision to go after Yukos, one of the country's two biggest oil producers. Iraq, another potentially promising source, has seen its oil infrastructure come under almost daily attack from insurgents.

If the spare capacity were greater, none of these situations would seem so threatening. But a repeat of last year's oil workers' strike in Venezuela, for instance, would be a disaster. Even a relatively routine occurrence -- a quickly extinguished fire that shut down a BP (BP ) refinery in Texas -- helped send prices up more than $1 a barrel on Aug. 6.


  Another factor: Hedge funds have discovered the oil markets as a volatile asset class that isn't correlated with other securities markets. The presence of these financial investors may add to volatility and accelerate momentum in price runups (see BW Online, 8/6/04, "Hedge Funds Are Everyone's Problem").

Finally, it doesn't help that the Bush Administration lacks an energy policy worthy of the name. In fact, analysts question why the U.S. government will continue adding to the strategic petroleum reserve when the markets are so tight. The Interior Dept. announced on Aug. 6 that it will be adding 100,000 barrels a day for six months, starting Oct. 1.

What will it take to calm worries? A substantial buildup in inventories, which are now well below their 5-year averages. But with little sign of slowing demand, such a change doesn't look likely in the near term. Oil prices are notoriously volatile and unpredictable, but anyone betting on a quick return to cheap gasoline and other oil products is likely to be disappointed.

Reed is London bureau chief for BusinessWeek

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