The unpredictable forces behind oil prices

Spencer Platt/GETTY IMAGES - Traders work in the crude oil and natural gas options pit on the floor of the New York Mercantile Exchange.

For people who believe that oil markets are rigged or broken, the first week of May offered Exhibit A.

That week, the price of crude oil plunged more than $16 a barrel, erasing about $32 billion of the market value of Exxon Mobil and presaging an easing of prices at the pump, where the cost of a gallon of gas had hit record levels.

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On that Thursday alone, the price of oil fell off a cliff, tumbling more than $10 a barrel.

Yet the physical amount of oil in the market didn’t change that week. Libya’s oil exports had been offline for more than two months. In the oil world, the surface was relatively calm. But a couple of signs of economic weakness spooked traders, who suddenly worried that demand would be less than they had expected. Goldman Sachs, a believer in rising crude oil prices, predicted a temporary pullback. Poof! More than a tenth of the value of a barrel of oil disappeared.

For consumers, oil prices are like a bad case of malaria — feverish one month and tolerable another. Such wild fluctuation makes it nearly impossible to discern: What is the right price for oil?

Today’s crude oil prices are nearly 10 times as high as they were in 1998, and twice as high as in 2005. They hit a record of $147 a barrel in July 2008, only to sink to less than $40 a barrel by the end of that year.

In March, amid intense fighting in Libya, President Obama said that there wasn’t a serious supply shortage and that rising oil prices weren’t reason enough to tap the nation’s Strategic Petroleum Reserve. Then on June 23, he suddenly said that turmoil in Libya justified the largest-ever release of reserves.It was more of an economic stimulus than a national security measure.

Because oil prices fluctuate so much, however, it will be impossible to measure Obama’s success or failure. If prices continue to drop, as they were doing before his move, will he deserve credit? If they rise, will he deserve blame? If it works, will we want him to do it again?

That will come down to the question of price.

In a competitive market, the price of oil would be linked to the marginal cost of the next barrel. In other words, the price for the first 88 barrels would be affected by the cost of producing the 89th barrel, in effect the cost of replacing each barrel used.

But in the world of oil, it’s hard to say what that replacement cost is. Producing oil is not like churning out computer chips, where costs are similar everywhere.

In Canada, it costs somewhere between $40 and $60 a barrel to mine and melt the viscous goo known as tar sands that environmentalists would rather leave in the ground. Yet in the Gulf of Mexico, where giant drilling rigs plumb deep waters, the cost of finding and developing oilfields can be relatively modest. Chevron, for example, has a $7.5 billion platform that will tap into a half-billion-barrel field at an average cost of about $15 a barrel. In Iraq, it’s even cheaper. The country has giant, shallow fields as good as almost anything in Saudi Arabia. In some places, you could practically stick a spear in the ground and come up with oil. Those neglected fields are being rehabilitated — if fighting can stop long enough.

And that’s the thing: There is no free market. There are obstacles everywhere. Pipelines. Politics. Oil spills. Warfare. They make it hard to figure out a marginal price for the next barrel of oil because it’s not clear whether the cheapest barrel can get anywhere near a tanker, refinery or consumer.

Then there’s the demand side, where needs and habits are so ingrained that we don’t respond quickly to rising prices. Buying oil isn’t like buying fruit: If an apple costs too much, buy an orange. If your gas costs too much, there isn’t much choice for most Americans who need to get to work. As a result, a relatively small percentage change in world supplies can upend the whole balance — and price.

Obama, often faulted for not having an energy policy, took care of the most crucial energy policy item back in early 2009, when he raised fuel-efficiency standards for American cars, which consume one out of every nine barrels of oil produced worldwide. More recently, he’s been touting electric cars, which he says should number 1 million by 2016. Saving a barrel is even better than discovering one; it’s tidier, and more money stays at home. But with General Motors selling only about 450 of its Volt plug-in cars a month, I don’t think OPEC is quaking in its boots.

The Organization of the Petroleum Exporting Countries is devoted to the idea of managing — or manipulating — oil markets.

Though Saudi Oil Minister Ali al-Naimi emerged from the cartel’s cantankerous June meeting and declared it the worst one ever, when it comes to oil prices, OPEC is having its best year ever.

So far this year, the price for a basket of different OPEC crude oils has averaged $106 a barrel, 38 percent higher than last year and higher so far than the previous record in 2008. OPEC’s “hawks,” led by Iran and Venezuela, want higher prices. OPEC’s “doves,” led by Saudi Arabia, want prices just high enough to keep consumers on the hook without driving them to alternatives.

Meanwhile, money has been sloshing around the world. Just as oil consumers are clawing back from two years of recession, they are suddenly paying $2.5 billion a day more than last year for petroleum products. About $1.8 billionof that flows into the coffers of the three biggest oil-exporting nations — Saudi Arabia, Russia and Iran — while more than $1 billion is draining out of the United States to pay for imports.

Higher prices reflect a political risk premium. If you think there is a 30 percent chance that some disruption — say a bomb or a civil war or a NATO attack — will soon drive prices up by $50 a barrel, it might make sense to pay an extra $15 for oil now and stockpile it or buy for future delivery.

The windfall for Saudi Arabia has enabled King Abdullahto spread around a $40 billion spending plan to help avoid a Cairo-style uprising.

Meanwhile, at the local filling station in the United States, a tank of gas is about $15 more expensive than last year, bringing the U.S. economic recovery to a crawl and creating a combustible political issue.

That’s intensified the Washington blame game.

The big oil companies, which once dictated prices to the world, now say that they are just “price takers” at the mercy of the market, like the rest of us. Yet they reap benefits when OPEC does. Only a dozen countries produce more crude oil than Exxon Mobil. Big Oil bargains over access, taxes and its share of output, but it checks the computer terminals for price.

The increase in crude prices this year was magnified by the nation’s refiners, whose margins were at least 17 to 23 cents a gallon higher than last year, according to government figures. The Federal Trade Commission is investigating the concentration of ownership in gas stations. In the District, for example, about half of the stations are owned by a single firm. It sounds like a question from the final exam of an antitrust course.

Republicans, big business and oil industry groups have slammed Obama for the one-year pause in drilling permits after the BP oil spill in the Gulf of Mexico. Citing a study paid for by the American Petroleum Institute, oil executives say crude oil output fell by more than 100,000 barrels a day. Yet Severin Borenstein, co-director of the University of California’s Energy Institute, observes that “Obama’s actions have had virtually no impact on ‘current’ production, and the entire scope for changing U.S. production is tiny in the context of the world oil market and will have no noticeable impact on prices.”

Democrats usually blame “speculators” for soaring gas prices. And Goldman Sachs is usually high on the list. The investment bank runs some of the biggest commodity investment funds and has a widely used commodity benchmark composed largely of oil. Its influential analysts move markets.

Manipulation does happen. The most spectacular example is in natural gas, where prices dropped 8 percent in 14 seconds in after-hours trading on June 8.The Commodity Futures Trading Commission is investigating.

It happens in oil, too. Earlier this year, the commission charged two veteran oil traders with booking $50 million in profits by manipulating oil markets in 2008. They bought physical cargoes they didn’t need to artificially inflate prices while also buying derivatives so they would profit as prices rose. They bought other derivatives that would pay off later when prices fell — which they did after the pair sold their physical barrels, catching other traders off guard.

But in general, “speculation” is a loaded term for what investors do every day. Cornering a piece of the market can warp prices, but usually for a limited time.

There are gushers of theories to explain the longer-term picture framed by the basics of supply and demand.

Some argue that an era of limits has begun. Yes, there is a peak to world oil production out there somewhere, because we’re gobbling up the plants and plankton that have been simmering for millions of years in the sedimentary cooker faster than the Earth can replace them. But we keep postponing that peak — by finding new fields, getting more oil out of old ones or clamping down on consumption.

Still, supplies could remain tight because of fast consumption growth in China, where every year it’s increasing by more than half a million barrels a day, and in India. The world has about 3 million to 4 million barrels a day of spare capacity right now, but prices edge up when that cushion shrinks.

The only way to restore balance in coming years will be through higher prices — but that could constrain economic growth. Robert McNally, founder and president of the Rapidian Group, estimates that prices will have to rise 13 to 15 percent a year to effectively ration supplies. “You can have 4 percent economic growth or double-digit crude oil prices,” he says, “but you can’t have both.”

That goes back to Obama’s release of strategic reserves. “The administration will be repeatedly tested” on its strategic oil reserves policy, McNally says. “If you believe half of this [scenario], how do you get reelected next year?” he says. “You have to prevent the rationing. So you have to throw the reserves into the market.”

By Wednesday, a week after Obama and the International Energy Agency unveiled their oil reserve plan, petroleum prices had rebounded, recovering nearly all the ground lost immediately after the announcement.

It remains unclear whether the president pays a political price, and what price we’ll all pay for oil.

outlook@washpost.com

Steven Mufson covers energy for The Washington Post.

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