Oil Prices: The New Reality

Futures traders are already assuming sky-high prices are here to stay

Everyone knows it: oil prices have gone through the roof. The price of benchmark crude rose 11% this year alone, to about $67 per barrel, before pulling back a little. But many in the industry have always figured that prices would sooner or later simmer down. One indication: Even when short-term prices soared to alarming levels, the futures market had until recently valued oil much more modestly. As new supplies came onstream, traders figured, prices would drift back down to their long-term average, which for years was about $20 per barrel. This thinking still influences the big oil companies, who have held back from investing massively in new projects.

But the futures market is now sending a radically different, and disturbing, message. Until 2002, oil futures rarely moved above $20 per barrel, and by 2005 they still lagged current prices. But in the last year long-term futures prices have been soaring, reaching $62 per barrel for benchmark West Texas Intermediate crude for delivery seven years out. Paul Horsnell, an analyst at London-based investment bank Barclays Capital (BCS ), says the markets are sending a message: "Whatever the long-term price is," he says, "it is not $20 per barrel."

Horsnell and other analysts believe a profound rethink about prices is occurring, with the market trying to figure what price will spur new production without killing demand. As a result, they say, the world has to prepare itself for a long stretch of oil at $50 to $60 or higher. There are plenty of reasons for the shift. New reserves from non-OPEC countries aren't materializing. Countries with big reserves such as Iraq and Iran are either unable or unwilling to develop them. Spare capacity in the world's oil fields is almost nonexistent, as demand continues to soar. Göran Trapp, managing director of commodities at Morgan Stanley (MS ) in London, also notes that fast-growing consumption is outstripping the industry's storage and distribution system. He uses a homey metaphor to explain the predicament: "If your family doubles in size but your fridge stays the same, there is a risk you will run out of milk."


Short-term and long-term prices would both ease if the world had more excess petroleum capacity. But right now spare capacity is a razor-thin 1.5 million to 2 million barrels a day, nearly all of it in Saudi Arabia. That's around 2.5% of world production, a very small margin for error. And it's even worse than it seems because refiners sneer at the heavy sulphurous crude oil that makes up much of the extra oil supply.

Horsnell thinks that it might take spare capacity of as much as 10%, or 8 million barrels, to calm the market's fears of disruptions. The best way to boost world output would be through increases in production from Iraq and Iran, which have large reserves. If these two countries were producing a combined 10 million barrels per day rather than the current total of 5.6 million barrels, prices would likely be a lot lower. But it will be tough for either country to attract the billions in investment needed to reach such levels.

The rest of the oil patch is struggling, too. Year after year the growth of production in non-OPEC countries, where big international companies have focused most of their efforts, has been disappointing. Last year, despite a surge in production in Russia and Angola, non-OPEC output did not grow at all because of sharp drops in output in the U.S. and the North Sea fields off the coasts of Britain and Norway. At the same time, world demand grew by 1.52 million barrels a day. All of the excess had to be made up from OPEC.

Some observers still think today's prices could come tumbling down. "Going by the cost of finding and developing oil today, there is no reason why the long-term price should be at $50-plus," says Leo Drollas, deputy director of the Center for Global Energy Studies, a London-based think tank. Drollas theorizes that a surge of hedge fund capital has pushed futures prices up, temporarily altering market dynamics.

Maybe so, but there seems to be little chance of a quick escape from prices that would have been considered astronomical a few years ago.

By Stanley Reed

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