Causes of High OIl Prices in 21st Century

The recent run-up of the price of oil to first $100 / bbl and now to over $140 / bbl has been caused by a correlation of forces. Most of these forces are nothing new and have been around for over 30 years. The oil markets were studied quite intensively in the mid and late 1970s after the first oil price shock. Books were written; Ph. D. dissertations were produced; numerous academic and industry studies were done. Your author read some of those and even took a class at a ... gasp ... Harvard graduate school mostly devoted to the world's energy future. Not much has changed.

Here are the facts and forces.

1. The short term elasticity of demand for oil is very, very small, a FACT known for decades.
2. Major oil fields are in decline. All oil fields eventually produce less per year and eventually run out. This applies to all major fields developed in the 1960s, 1970s, and realy 1980s, viz. the North Sea, Mexico, Russia, and some in the MidEast. US oil fields are nearly depleted, except off-shore. [By the way, the US was the #1 oil producer for many decades up to the 1960s].
3. All new production such as from Angola merely goes to replace lost annual production from item #2.
4. Oil supply is a flow problem - the key number is the number of barrels produced PER YEAR, not the total still in the ground or accessble at high cost.
5. Demand is also a flow problem - The world economies have demand for a growing number of barrels of oil PER YEAR. Once the Soviet Union broke up and eastern Europe was permitted to develop normally, demand from there increased substantially. Demand from India and China has grown enormously.
6. Oil supply is approximately at its practical limit - about 85 million barrels per day.
7. Oil demand recently approached and hit that number. Barring price rises, demand would be over that number.
8. So under free market economics, price must rise to ration that last available barrel per day.
9. How much ? See item #1. A lot. Oil prices rose from the low double digits to $80 and then $100 / barrel. At those levels, modest declines in demand from the US were measured. This is a fact. Until prices rose to $80-100 / barrel, the American consumer did not cut back. At $100, they did.
10. Most oil traded on commodity markets is a fairly high grade of oil, not the heavy, sour grades that are the marginal barrels produced by Saudi Arabia.
11. There is really little truly "free" high quality oil on the markets - that is, not under contract or owned by governments. Financial Times recently put that number at about 5 million barrels per day out of total production of 85 million barrels per day.
12. For a few years, massive amounts of money - hundreds of billions - from pension funds has flowed into long only positions in the commodity markets. About 50% of that goes to oil and related products. The pension fund money is long-only. Massive flows into energy hedge funds occured, too. Whether made directly in the futures markets or via swaps, all these eventually cause massive long positions in enegry derivatives. These are DERIVATIVES - not actual barrels in the ground. This is differrent than investment in timber or gold where physical trees or bars of gold are owned. Fro a derivative, for every buyer there must be a seller.
13. There are really few natural sellers of oil futures. Who can do this ? Oil companies. That's it. governements don't sell oil in the futures markets. OPEC doesn't. And oil companies limit the amount they will sell forward.
14. So the pension funds have overwhelmed the natural sellers of oil futures and driven the prices up from a natural range around $100 / barrel to over $140 / barrel.
15. US consumer and industrial demand is dropping quite a lot now. The summer driving season that usually would cause a peak in gasoline demand seems to have vaporized. Demand is down about 3-5% year over year. Since the US is the largest consumer in the world, that's a lot of oil demand destruction.
16. Many nations in Asia subsidize the price of oil. That prevents market forces from rationing demand there. China recently raised gasoline prices, so in some places that distortion is lessening.

What next ?

Price will remain elevated. That is simple. No new supply and a continual flow of people and industries in growing economies thinking they'd like a bit more. Some marginal demand must be rationed by the high price. How high ? Very high until Congress kicks the pension funds out of the oil derivative markets (where they were in fact prohibited from being until a few years ago). If pension funds want to invest in oil, let them buy it in the ground or drill for it. Position size for hedge funds must be limited, too. And all-encompassing regulation on derivates is needed to prevent these beefers from getting around the limits with the help of Wall Street firms.

My guess from demand response that I've noticed over the years is that about $100 is a natural price balance. Demand was indeed being rationed at that level. The rest is the pension funds and beefers.

Other issues:
A. Most refineries have problems using heavy, sour grades of crude oil to make gasoline or diesel fuels - using it requires technical changes and costs more.
B. The spread between the prices of grades of oil has grown to record amounts - viz, the high quality price less the low quality price.
C. Congress, in its perpetual stupidity, mandated use on only very low sulfur diesel fuel in US trucks. This is hard and costly to make from cheaper, sour grades of crude oil.
D. Over time, new refineries can be built to use lower grades of oil. This is being done now - not in the US, of course - as US Congress and environmentalists want to grind the common man down and limit his freedom.

PS: Unless drilling is permitted and large amounts of money is invested in hard-to-recovery fields, such as in deep water or the Arctic, oil prices will rise as far as the eye can see. Why ? Because more oil must come into production to replace the production to be lost in near future years from declining fields.

PPS: I made a large add to my CCJ position this morning. This is the largest uranium mine in the world. Being a mine, there are always production risks. But long term, uranium must be the growth energy source of the 21st century. From Barron's quoting Nicholas Sarkozy, President of France, "The era of cheap oil is over. [The world] will end the 21st century without oil." said as he unveiled plans to expand France's nuclear plants. The monthly chart shows a solid two year base. The PE is a reasonable 22-23x with a five year compound earnings growth rate of 32%. I intend to make this one of my top ten stocks by position size.

Word of the Day

"Conspectus" - noun [$10]
Conspectus means 1. a general or comprehensive survey; 2. a summary or synopsis.
Sentence: Today Bunkerman wrote a conspectus in his blog on the causes of the increasing oil price in the last few years.