Friday, April 18, 2008

Regular gasoline prices vaulted to a once unthinkable record of $3.42 a gallon yesterday, paining most Americans but pleasing a growing contingent of investors who are profiting from the fast-rising price of fuel.

Scott Lee, a small investor from Georgia who owns oil company stock, said it’s the reason he is not bothered by rising pump prices.

“People gripe about $3.30 gas. What about $4 gallon for milk or — even better — a $4 cup of some frothy coffee?” he said. “Gas has done nothing but keep up with the other markets. I just wish I had bought stock in oil companies” a decade ago when oil prices were one-tenth of today’s price of about $115 a barrel.

Economists say robust demand for oil in the developing world and strains in supplies worldwide account for some of oil’s spectacular rise, and pose the possibility of serious supply shortages in the next decade. But they say prices today are well beyond the point where they can be explained by supply and demand alone. A speculative fervor appears to be behind the latest round of price increases.

Oil has strong appeal to large and small investors alike both as a speculative and long-term investment, and as a hedge against inflation and the falling dollar. Oil and other major commodities are priced in dollars and tend to rise as the dollar falls. And the dollar’s decline has been accelerating since a financial crisis sent the United States into an economic slump last fall.

“The flow of liquidity into commodities as an inflation hedge” is a principal reason why prices are rising, said Nariman Behravesh, economist at Global Insight, along with strong growth in demand for fuel in China, Russia, India, the Middle East and other developing countries.

“Oil prices have overshot,” he said, “but they could stay high for some time.”

That comes as especially bad news to Americans, who have been cutting back on purchases of fuel in an attempt to lick high prices. Mr. Behravesh expects oil prices averaging more than $90 this year to continue to hobble consumers and a U.S. economy that already has slipped into a mild recession.

Few forecasters are willing to venture a guess as to how high oil prices will go. But T. Boone Pickens, perhaps the world’s most famous oil speculator, recently predicted the price of premium crude will reach $125.

Analysts say between 10 percent to 50 percent of the price of oil may be due to speculation. “A tidal wave of investment flows” caused a 20 percent jump in holdings of oil, gold and other commodities to $400 billion in the first quarter of the year, said Citigroup analyst Alan Heap.

Investors have been pouring money into index funds that track the rise in commodity prices, which jumped by $40 billion to $185 billion in the first quarter, a larger gain than the whole of 2007. Commodity traders and hedge funds have amassed huge holdings of oil and other commodities of $94 billion and $75 billion respectively, according to Citigroup.

Many small investors have been getting in on the action through exchange-traded funds (ETFs), which are easier to manage and cheaper than mutual funds and enable them to participate in volatile energy futures markets that were designed for large traders such as oil producers and refiners. ETFs accounted for $46 billion in commodity investments as of March 31, up 31 percent from $35 billion at the end of 2007.

Several Web sites cater to the increasing speculation in oil and other commodities, including, an online betting site where odds are running 6 to 4 in favor of gas prices reaching $5 a gallon at the pump this year.

“One can’t help but wonder just how far they’ll go, and what kind of impact the high costs will have on daily life around the globe,” said Esteban Siles, a spokesman for the site.

While the “hot money” flowing into oil markets has recently drawn scrutiny from Congress, many people favor oil as a long-term investment. Production of oil is expected to peak worldwide in the next 30 years, but demand keeps marching ahead as more and more people emerge into the middle class and start driving cars in countries like China, India and Russia. That means prices over the long term have nowhere to go but up.

Prices are high today, but the International Energy Agency expects the big crunch to come after 2010 when it is not clear whether enough supplies will be on hand to satisfy projected demand. While use of biofuels is growing as a replacement for gasoline, the agency said alternatives to oil likely will not be sufficient to prevent shortages of fuel in the next decade.

Production is already falling in countries that were top producers of oil in past eras. Those include the United States, Britain, Norway, Mexico and Venezuela. Even Russia — which leapt to the world’s largest producer after opening up to Western investment in the 1990s — reported a 1 percent decline in oil production in the last quarter.

Production is dropping in Russia and other key countries because they have driven out Western oil companies which have the sophisticated technology needed to keep producing at high levels. That is true of Mexico, where production is running 12 percent below 2006 levels, and Venezuela, where production is 6 percent below 2006 levels, the international agency said.

Venezuela has some of the world’s largest oil reserves, so its decline in output is entirely due to political factors. But even in countries like Britain and Norway which welcome Western investment, production has fallen 10 percent.

Average oil field production outside the Organization of Petroleum Exporting Countries has declined 7.7 percent a year since 2000. Saudi Arabia and other Persian Gulf states have been ratcheting up production to make up for shortfalls elsewhere.

One country where production has increased since 2006 is Iraq, where oil fields were opened to foreign participation after the U.S. invasion in 2003. Still, the persistence of violence and political instability there means those increased flows cannot be guaranteed.

“Countries closing their oil resources to foreign participation are the principal threat to oil supplies” in the world today, said Martin Hutchinson, analyst at “An oil industry with capitalism, foreign partners and technology has given way to autarky and state control.”

The decline in Russian oil output is not surprising, he noted, since the state has dismembered its most efficient oil company, Yukos, forcibly renegotiated exploration and drilling contracts with Royal Dutch Shell and BP and imposed an 80 percent tax on oil revenues above $27 a barrel. Venezuela also recently seized majority control of foreign oil concessions.

Nigeria, a major U.S. supplier whose production is running 10 percent below 2006 levels, taxes foreign oil companies profits at 98 percent, Mr. Hutchinson noted.

One bright spot on the horizon is Brazil, he said, which recently discovered a major offshore oil field with the help of Western oil majors. But much more will be needed in a world that consumes 86 million barrels of oil a day, he said.

“Large new oil discoveries are required to stop oil prices spiraling towards infinity,” Mr. Hutchinson said, and that will only come when the most promising oil fields are opened up to international development once again.

The rapid decline in oil production in Europe and North America increases the power of OPEC nation such as Saudi Arabia, Iraq and Iran, which supply 45 percent of the world’s oil but have the capacity to produce more as they own three-quarters of the world’s oil reserves, said Ioannis Michaletos, analyst with the World Security Network Foundation.

“With the present consumption rates, the oil era will end in less than 40 years,” he said. The oil-rich states “will be the ones dictating the rules of the game during the last annum of the oil period.”

While long-term prospects are for oil prices to stay high, some analysts expect a setback in oil and gas prices in the short term as a result of recession and falling demand in the United States, which may spread weakness to the rest of the world. But they say that any fall in prices is likely to be only temporary.

“By the second half, we expect weakening economic growth [in developed countries] to limit oil demand in those markets, allowing oil prices to slip back,” said Robert Ward, analyst at the Economist Intelligence Unit. But the “ever-present threat” of supply disruptions in the Middle East, Africa and Latin America will tend to keep oil prices high.

Mr. Ward said the flow of speculative money into the oil market can cut two ways. Much of the money pouring into the market since the end of last year has been from investors fleeing the turmoil in global stock and bond markets.

But continued declines in those markets may also force financial institutions to sell off some of their oil holdings to cover their losses elsewhere, pushing oil prices down at some point, he said.


One factor behind rising oil prices is falling supplies. Here is a look at production decline rates among key non-OPEC producers:

Great Britain 21.5

U.S. offshore 19

Australia 18.5

Norway 16

Non-OPEC average 8.2

Africa 8.1

Middle East* 8

Other Asia 7

Canada 6.5

U.S. onshore 6

China 5.1

Latin America 5

Former Soviet Union 3

Graphic shows the rate of decline in oil production in non-OPEC producers from 2001 through 2007.

* Middle Eastern oil producers such as Bahrain and Oman are not in OPEC.

Source: International Energy Agency

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