Tuesday, July 07, 2009

Why has the price of oil climbed so high?

After it crashed from $140/bbl in July 2008 to $33/bbl in December 2008, it has risen again t0 $65/bbl. Now the explanation that the recession caused the crash in price last year seems pretty weak given oil's recovery this year. The recession hasn't gone away, after all. The New York Times has some explanations:
Many factors that pushed oil prices up last year have returned. Supply fears are creeping back into the market, with a new round of violence in Nigeria’s oil-rich Niger Delta crimping production. And there are increasing fears that the political instability in Iran could spill over onto the oil market, potentially hampering the country’s exports.

The OPEC cartel has also been remarkably successful in reining in production in recent months to keep prices from falling. Even as prices recovered, members of the Organization of the Petroleum Exporting Countries have been unwilling to open their taps.

Top officials said that OPEC’s goal was to achieve $75 a barrel oil by the end of the year, a target that has been endorsed by Saudi Arabia, the group’s kingpin.
But they are not totally convinced that this makes sense.
The World Bank warned the recession would be deeper than previously thought and said any recovery next year would be subdued.

The International Energy Agency held out the prospect that energy demand was unlikely to recover before 2014. Yet the indicators that would traditionally signal lower prices — like high oil inventories or OPEC’s large spare production capacity — do not seem to hold much weight today, analysts said.

“Crude oil prices appear to have been divorced from the underlying fundamentals of weak demand, ample supply and high inventories,” Deutsche Bank analysts said in a recent report.
So, as I like to ask, wha'happen? Philip K. Verleger, as reported in the L.A. Times, says the following:
With so much oil available and so little need for that amount, investors, oil companies and even some banks have bought and stored surplus oil everywhere they can. By one estimate, before oil surged to its high this year of $73.38 a barrel in June, as many as 67 supertankers -- each capable of carrying 2 million barrels of oil -- were being used as floating storage.

Verleger said it represented a largely risk-free investment for those who could sell that oil for huge profits on the futures markets.

But the glut has gone on for so long, he said, that the cost of all of that storage is bound to rise. When it rises enough, some suppliers will refuse to pay and a lot of that oil will be dumped onto the market.
Now one wonders why producers would be storing oil--why not just not produce it and "store" it in your reserves? But you can definitely see why banks and other investors would pay to store oil in tankers. Oil for August 09 delivery has a forward price of $64.05/bbl. Oil for August 2010 delivery has a price of $70.80/bbl. As long as interest rates are low and the cost of storage reasonable, it makes sense to hold the oil in storage. Or, to use jargon, as long as the forward curve is sufficiently upward-sloping or contango, storage makes sense. Assuming that storage contracts are long-term, it could take many months to unwind this. But it would unwind, and as that oil is released, the price of spot will drop. But as it unwinds, the cost of storage drops, and as long as the forward curve is contango, people will start storing oil again, constricting supplies, pushing spot back up.

Could this feedback loop be what is causing the extreme volatility in the oil market?

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