Energy Views

We saw crude oil start the year 2008 at about $98 per bbl. for the Cushing WTI weekly average spot price. From that point, the price dropped to a little below $90 per bbl, and then rose to the current $127 per bbl. in May 2008. This all time high for crude oil is at, or near its peak. There are other factors coming in to play as described below, which I feel will soon cause a decline in crude oil prices..

Of course the question now is where does the price go from here. To try to predict this, one should examine the factors that might influence the price of oil. Many now refer to crude as the new commodity that replaces gold as a commodity in which to hedge the value of the dollar. We do know that the number of crude oil future contracts have increased dramatically since Jan. 1, 2008, from 5 million contracts per day to 20 to 30 million contracts per day (see Crude Oil Lt Sweet Pit (Nymex) June , 2008).

This might indicate that the speculators (hedge funds and institutional investors) have migrated to the crude oil market from other markets. However, in a March 31, 2008 teleconference, President Red Cavaney of the American Petroleum Institute questioned whether institutional investors are driving oil prices higher. He quoted Alan Greenspan as saying, “When people buy oil for non-commercial accounts, they provide liquidity for the markets.” While this may be true, when more and more purchasers start buying a limited amount of a commodity, common sense will suggest that this has to drive the commodity price up to some degree. It is my opinion that these type investors who are now investing in oil future contracts will exert an upward pressure on the market, but may be only one of several upward pressures being exerted.

Another pressure might be in the fundamentals – how much supply is available, and how much demand there is. In a normal market, an increase in demand for a finite amount of a commodity (which would result in a decrease in inventories) would cause the price to rise. But not so with crude oil: since January 1, 2008, the spot price for crude oil has been rising in spite of an increase in crude oil inventories. See the following graph. (As seen in this graph, as the inventory rose from 295,000 thousand bbls. to 325,000 thousand bbls., the price increased from approximately $90 to $120 per bbl.)

From the data in this graph, it is apparent that the normal relation of supply vs. price has not been occurring since January 1, 2008. So what else could be impacting the price of oil?

Many analysts attribute at least part of the oil price rise to the decrease in the exchange rate of the dollar. Almost all crude oil world wide is sold for U.S. dollars. So if the exchange rate for the dollar against other currencies falls, it is necessary that the number of dollars required to buy crude oil rises to account for the increased cost to the crude oil seller to keep him whole on other goods he may purchase from other countries. Since the first of the year, the dollar has fallen from $1.00 to buy 0.681 euros (the universal European currency) to $1.00 buying 0.631 euros. A graph of the price of crude oil vs. the exchange rate correlates very well indicating the relationship of a drop in dollar exchange rate will cause a rise in crude oil prices.

See the graph below:

So for the $64,000 question of which way oil prices will go, that depends on several factors:

1. With respect to supply, world wide consumption of crude oil has been climbing rapidly, but there are indications that the increase in crude oil prices is causing demand to taper off somewhat, in the U.S. as well as other net importing countries (including China and India.) This week, the IEA reduced their forecast for demand of crude oil, and indicated that they may drop it again in the near future. If demand does indeed decline, this will cause the price to drop somewhat. But there is the cause/effect: a decline in prices will again stimulate consumption.

2. For the U.S., a strong dollar would cause a decline in prices for the U.S. For other countries, the change in price would be minimal since after exchange for dollars, there would be little change in their costs based on their currency. So what are the chances of this happening? As of right now the Bush Administration and the Federal Reserve are attempting to hold a weak dollar, presumably to aid export sales, and to decrease imports. This may change with a new administration, but chances are it will take a change in Federal Reserves policies. So it does not appear likely this will happen soon; in fact, we may see additional declines in the exchange rate on the dollar which will cause the price of crude to rise some more.

3. What about the impact of institutional investors trading in crude oil futures? Institutional traders move from one investment to another, depending on what appears to be the best investment. With the crash in real estate values, I would not be surprised for them to soon start “bottom fishing” in real estate and move some of their money from oil futures to real estate. So I expect to see the number of contracts traded to decline during 2008 because of the institutional investors moving on to other markets, and this will remove some upward pressure on crude oil prices.

4. As for inventory, the cost of carrying inventory is expensive at the price of crude oil now. So I expect the U.S. users of crude oil to soon start decreasing their import purchases, and cause their inventories to level out. This will cause a downward pressure on prices, unless the rest of the world can absorb all oil not taken by the U.S., (but I do not think this likely: other countries will be reducing their demand at the same time.)

If we combine the above four items, I expect that Nos. 1,3,and 4 will exert some downward pressure on crude oil during the next 6 months, and No. 2 will exert some upward pressure. The results will be the price is near its near term peak now, but is not likely to decline below $100 in the next 6 months. Then long term, the price will rise due to increasing demand and limited supply.

And all of this assumes no major war or other major geopolitical event.