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Crude Hypochondria

Oil Hysteria Driving Price More Than OPEC Supply, Global Demand

By Steve Schippert | May 19, 2008

America's greatest strength in wartime has long been its economic and industrial might. Record oil prices are damaging this capacity. Yet the cause for the sustained spike in oil prices has less to do with increased global demand or fluctuations in supply than most acknowledge. Rather, an irrational market panic is by far the greatest variable in the economic equation. Nevertheless, we continue to look to address the problem by cajoling or even intimidating the suppliers. Regardless of what one thinks of OPEC states, their supply is neither the primary cause nor the principal cure to what ails us.

The UK's Telegraph reports on the latest regarding OPEC's refusal to increase crude production. With President Bush's visit to Saudi Arabia sparking the news cycle, this is last week's news. But within this article - surely the thousandth on the subject with similar content - is an economic gold nugget from an unlikely source: OPEC.

Opec members blame market speculators and geo-political factors for pushing up the oil price, not a shortage of supply.

And that is absolutely 100% truth. Supply and demand are the fundamental arbiters of the price of goods. But the human elements of irrationality and panic set the equation askew. We would do well to recognize and acknowledge this cog in the system.

Have a look at this chart from WTRG.com which plots crude oil prices since 1970. It shows a stable price for nearly two years after the 9/11 attacks around $25 per barrel. The chart ends with January 2007 prices below $60 per barrel. Today's record price is over $130 per barrel.

Has Asian growth accounted for a 500% increase in demand? Hardly. Has the supply dropped by 500%? No. Have both factors combined for a 500% increase metric? Not even close.

What gives? The answer is precisely what OPEC says: Frantic speculation on tomorrow's supply, compounded daily, and geo-political events that have driven this hysterical perception.

So convinced are our markets today that tomorrow's supply is going to evaporate, we place a crisis value on today's barrel. Tomorrow, we are surely even closer to fossil fuel doom and thus that day's barrel will be even more critical than the day before. Lather, rinse, repeat. $132 per barrel crude prices are returned from the calculus. Yet, it's basic math dictated less by true supply and demand and much more on the hysterical perceptions of the same.

We have become oil hypochondriacs. We are so convinced that we have cancer, it has inevitably appeared on our psychosomatic charts. So assured are we that doom awaits in perpetuity that we drive our own listing ship fearing that it will list port side any moment now.

It's an amazing phenomenon to behold. OPEC members adore the windfall breezes. Our enemies - chiefly Iran - are at times kept economically afloat by little else domestically. Others, such as presumed ally Saudi Arabia, are simply enriched at a breathtaking clip.

With Saudi Arabia's raw, unrefined product being sold at 5 times its going rate of just a few short years ago, our influence with them is reduced reciprocally. When President Bush visited the Kingdom of Saudi Arabia last week, is there anyone who truly envisioned anything but a resounding 'no' from them when asked to please increase output? What do we have that is as valuable in trade as our own windfall hysteria?

We still don't seem to recognize our own perceptions as part of the diagnosis. While President Bush chose the once-proven method of courting the Saudis, presidential hopeful Hillary Clinton chose to threaten them and vowed to "go right at OPEC" if she is elected president. Clinton said of the OPEC influence on oil prices, "That’s not a market. That’s a monopoly." There's a fundamental flaw to this thinking; it's their oil, not the world's complete with common rights to access. More importantly, and even more fundamentally, she too misdiagnoses the nature of the problem, which is our own out of control perceptions and panicked speculation. Whether we court or threaten the world's top crude oil suppliers, this is not the medicine to treat the proper disease.

We lend far too much credence to the impact OPEC has on the amount of money we are apparently willing to pay for their resource. It is not as if supply and demand have fluctuated commensurate with a 500% increase in market prices.

But if our hypochondriac diagnosis is cancer, the cure seems to have been determined to be taking up smoking. The ailment is here, not there. If the fear is the crippling effect of oil prices on our economy, and our chosen redress is to increase supply, why do we trek across the globe for relief shipments rather than tap into our own resources here at home? Why do we seek to control or influence others and increase our access to what is theirs without any effort whatsoever to further harvest what is ours, be it in Alaska or off our coastal shores?

Russia is staking underwater claims in the Arctic around the North Pole. China is drilling just off the Florida Keys. The prospect of Chinese slant drilling at the edge of our maritime territory is both bold on their part and embarrassing on ours. With Chinese rigs potentially at the edge of international waters drilling down at an angle to extract from beneath our territorial waters what we refuse to harvest, we may well have settled on smoking to cure our cancer, but just what it is that we are smoking is far from clear.

At any rate, even forgoing OPEC courtship or OPEC threats, accessing our own reserves at home merely addresses supply. And it should be clear that supply is not the cause for the unprecedented - and likely enduring - spike in crude oil prices. Nor is demand. Whether Alaskan oil or Arabian oil, most of the going rate for either remains largely driven by our own market hysteria. Until we can recognize and address that, we will remain in this aspect our own worst enemy, eroding unnecessarily our greatest wartime asset going back through World War II - an unrivaled economic and industrial powerhouse capacity.

There are very valid concerns about future supply, just as there are very valid concerns about increasing global demand. And we can and should address our own accessible supplies as well as usage conservation and alternative energy development. Yet none of these are short-term endeavors nor does any one of them address the causation most responsible for the spike in market oil prices: 'Crude' hypochondria.

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Oil output worldwide has kept relatively stable for the last few years, industrial production (amongst others) not, it has increased, where has the extra energy come from to power it? The value of anything is speculation, now that housing has been 'trashed',along with various related investment spheres, people are realizing that energy (ie. oil) is a sure bet, and the money follows, along with an increase in prices.We could even suggest that oil is still a long way off price wise from its real value.The main question economically for a country has been to keep the money within a countries own circuit to avoid trade imbalance and foreign empowerment. Time to study the options.

I agree that the run up in prices above $100 is almost entirely a function of a speculative frenzy in the often opaque oil markets, and have examined the fundamentals of the crude market in detail on my blog. The recent SPR/CFTC re-regulation moves plus Saudi's 300k of extra supply should help at the margin, but as with tech stocks and then housing, laissez faire financial capitalism is once again generating a destabilizing bubble.

The very idea of having the president of the United States ask the Saudis to increase supply - and for it to become publicly known that he was planning on doing this - was ill-conceived. Statements by Saudi Oil Minister Ali Naimi and other Saudi officials (in Arab media) have made very clear that they were not inclined to comply, except perhaps with a minor increase to help the president save face. In fact this was an embarassing screw up on behalf of the White House staff to even allow this pre-trip talk about speaking to the Saudis about the issue to percolate. There was no basis for expecting the answer to be yes.

I agree that speculation plays a role here, but have two points I would add to that.

First, the depreciation of the dollar is probably the single most important factor in driving oil prices higher. Petroleum is priced in dollars; when the supply-demand balance sets the price of a commodity at a given level, and the value of the currency declines, then it takes more of that currency to purchase a unit of the commodity. As long as U.S. interest rates remain low and other factors weighing on the dollar persist, high oil prices will persist.

Second, I wouldn't discount the influence of increasing demand and supply problems which have arisen in Mexico, Nigeria and elsewhere. Even if supply and demand were the only variable, it wouldn't take a 500% increase in that variable to produce a 500% increase in price. I don't think that prices function in such a linear fashion. If demand increases just 20% and supply for a product remains constant, prices can increase much more than 20% as long as there is demand-side elasticity. Elasticity of demand is determined by how much prices can increase without consumers pulling back. The demand curve for petroleum is fairly elastic because most people cannot cut back dramatically on driving since it is - in the U.S. anyway - a necessity of life. We have very recently seen a slight letup in demand, but that came only have huge increases in prices.

Of course Kirk is correct, especially when it is realized that YTD, Canada and Mexico (our #1 and #3 oil sources) represent exactly twice the oil from Saudi Arabia. It all comes down to what the Preident of Shell Oil said to Congress yesterday in his testimony before a very acrimonious Senate hearing:

"As U.S. consumption of oil has doubled, domestic oil production has fallen off nearly 40%. Why? In large part, this is the result of government policies that placed important oil and gas resources off limits."

"We still have a significant resource base in this country, both offshore and onshore. The U.S. government estimates that there are about 300 trillion cubic feet of natural gas and more than 50 billion barrels of oil yet to be discovered on the Outer Continental Shelf surrounding the Lower 48. When you then add in the Alaska OCS resource, you add the potential for another 122 trillion cubic feet of natural gas and 25 billion barrels of oil."

"Unfortunately, 85% of the Lower 48 resource base is off-limits because of Congressional moratoria."

Its time to get serious about safe drilling and retrieval of our own oil reserves at the same time that demand reduction/conservation occurs.