Oil Price Defies Easy Calculation
Gasoline Sets Record at Pump Despite Struggles in U.S. and Overseas Economies

By Steven Mufson
Washington Post Staff Writer
Friday, April 11, 2008

Is there a fair price for oil?

It doesn't seem that way. Over the past year, the price of crude oil has nearly doubled even though oil inventories are ample, there has been no disruption in supplies, and petroleum demand in the United States, the world's biggest consumer, has leveled off in recent weeks as the economy has slowed.

"There may be [a fair price] but it would be difficult to get consumers and producers to ever agree on it," said Guy F. Caruso, administrator of the Energy Department's Energy Information Administration (EIA). "Ideally, if there was a more competitive market, we might find out. But it's not the world we're living in today."

That's been evident this week. On the eve of the summer driving season, crude prices defy gravity, hovering around $110 a barrel, keeping gasoline prices at record levels and sapping money from cash-strapped consumers. Yesterday, the AAA auto club said prices at the pump set records of $3.357 a gallon for regular unleaded gasoline and $4.045 for diesel, even though U.S. gasoline consumption fell 0.6 percent in the first quarter.

That could make oil prices a politically volatile issue this year among voters who think prices are excessive and are looking for someone to blame. Yesterday, Sen. John McCain (Ariz.), the presumptive Republican presidential nominee, backed Sen. Byron L. Dorgan (D-N.D.) in calling on the Bush administration to suspend additions to the Strategic Petroleum Reserve, which is currently taking about 70,000 barrels a day of high-quality crude oil off the market. The two rivals for the Democratic nomination, Sens. Hillary Rodham Clinton (N.Y.) and Barack Obama (Ill.), had already endorsed Dorgan's proposal.

That would help, oil experts say, but it would be a drop in the bucket in a world where consumers use about 87.5 million barrels a day.

If consumers are baffled by the rising prices, so are many oil experts. "The fundamentals are no problem," Jeroen van der Veer, chief executive of Royal Dutch Shell, said in a recent interview. "They are the same as they were when oil was selling for $60 a barrel, which is in itself quite a unique phenomenon." He blamed the lack of spare oil production and refining capacity, and tensions in the Middle East, for keeping prices high.

Yesterday, Citigroup became the latest bank to raise its oil price forecasts, upping its estimate of the full-year average for 2008 by 20 percent, to $96 a barrel, and boosting its 2009 estimate by 17 percent, to $88 a barrel. When the U.S. economy is weak, banks generally lower their expectations for oil prices.

"There is no question that the continued strength in oil prices continues to challenge perceptions of what constitutes a 'sustainable' level," Citigroup oil analyst Doug Leggate said in a report. "The oil price outlook arguably remains more subjective than ever and hence leaves any long-term oil price assertion equally subjective and somewhat irrespective of traditional 'fundamental' analysis."

Many oil experts point to big hedge funds, investment managers and pension funds, which are pouring money into commodity markets.

The custodians of California's main public-employee pension fund, CalPERS, decided in December to more than double the amount of money invested in a commodity index fund, to $1 billion this spring. Though that's a small portion of the fund's assets, the figure is still significant; by 2010, the fund could boost its commodity stake to as much as $7 billion. The fund said that about 65 percent of those holdings would be in energy.

"It is the vision of our chief investment officer, Russell Read, who believes that in the coming decades natural resources are going to be where the action is," said Clark McKinley, a CalPERS spokesman.

CalPERS says its commodities stake falls into the category of "inflation-linked assets," and rising expectations about inflation are sustaining the flow of money into commodities, which in turn is fueling more inflation.

"I think more cash will come in and keep coming in until people are convinced that the Federal Reserve is going to do something about inflation," said Philip K. Verleger, an Aspen, Colo.-based oil analyst.

Verleger estimates that the flow of money into oil commodity investments rose from $450 million a week to $3.4 billion a week from the time the Fed cut interest rates in January until mid-March. Unlike traditional oil traders, the hedge, investment and pension funds are buying oil to diversify their portfolios, he said. That means that high oil prices have not stopped them from buying more.

That could alter the nature of oil markets, which have swung up and down ever since oil was found in Pennsylvania in 1859. Traders in commodity markets are now expecting continued high prices. On the New York Mercantile Exchange, the delivery price of crude oil for any month through December 2016 is no lower than $99 a barrel.

Global factors matter, too. The Organization of the Petroleum Exporting Countries cut production in January 2007 to keep prices from falling below $60. Rapidly increasing oil consumption in developing countries such as China is also propping up prices. And it is becoming harder to find new oil.

Shell's Van der Veer said he expects a crunch in energy markets in 10 or 15 years. "The easy oil and easy gas will not be sufficient," he said.

How that translates into today's oil prices is not clear.

Some economists say the price of oil today should be slightly higher than the cost of finding and producing a new barrel of oil. If that were the case, the price might be about $60 a barrel, the cost of getting oil from Canada's abundant tar sands.

Saudi Oil Minister Ali al-Naimi said recently that the Canadian cost was the new price floor -- even though world oil market prices only surpassed that level a year ago. Yesterday, Total chief executive Christophe de Margerie told an energy conference in Paris that "there is a new floor linked to costs" of developing new fields, and he said prices would stay above $70 a barrel.

Other analysts say the cost of developing new oil fields is much lower, as little as $10 a barrel, in much of the Middle East but that war in Iraq and restrained expansion in Saudi Arabia prevent cheaper oil from coming onto the market. Investment obstacles from Russia to Mexico also keep current production lower than it might be.

Still other economists say that the price of oil should be whatever the market will bear, and consumers have shown they can bear a lot. Although the EIA expects U.S. motorists to use slightly less gasoline than they did last year, that seems like a modest response, with pump prices at all-time highs.

Verleger argues that "fundamentals have never had much to do with prices. The floor for oil is around $10 per barrel. The ceiling has never been determined. What matters is market structure. Crude markets are not competitive. Instead, a few countries adjust output to satisfy buyers at the prevailing market price. These producers will happily accommodate index fund investors and pension fund managers as prices rise."

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