Q&A: Why oil prices keep rising

June 15, 2008
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Is the weak dollar one of the reasons?  At $120 a barrel, the world’s oil bill will account for eight per cent of global economic output, twice what it was in 2006.

Robust demand for crude and a weak dollar have fuelled the rally from a dip below $50 at the start of 2007. Adjusted for inflation, oil is now above the $101.70 peak hit in April 1980, a year after the Iranian revolution.

The fall in the value of the dollar against other major currencies has helped drive buying across commodities as investors view dollar assets as relatively cheap.

It has also reduced the purchasing power of Opec’s revenues and increased the purchasing power of some non-dollar consumers.

Opec oil ministers have noted that although prices are rising to record nominal levels, inflation and the dollar have softened the impact. Some analysts say investors have been using oil as a hedge against the weaker dollar.

What role does Opec play?

The Organisation of the Petroleum Exporting Countries, source of more than a third of the world’s oil, started to reduce oil output in late 2006 to stem a fall in prices. Fewer Opec barrels entering the market helped propel the rally.

While consumer nations led by the International Energy Agency have urged Opec to pump more oil, Opec says there is enough crude in the market. Few in the group believe there is much it can do to tame a market it says defies logic.

What about speculation?

Since the US Federal Reserve cut interest rates in mid-August last year and central banks pumped billions of dollars into financial markets to ease a credit crunch, oil and gold have risen.

Investment flows from pension and hedge funds into commodities including oil have boomed, as has speculative trading. At the same time, the credit crunch has brought some other markets, such as the US asset-backed commercial paper market, to a virtual standstill. Some of that money has found its way into energy and commodities, analysts say.

Will demand slow down?

Global demand, at 86 million barrels of oil a day, has not wavered.  Demand had slowed down after a surge in 2004 but is still rising and higher prices have so far had a limited effect on economic growth.

Analysts say the world is coping with high nominal prices because, adjusted for exchange rates and inflation, they have been until now lower than during previous price spikes and some economies have become less energy intensive.

While previous price spikes have been triggered by supply disruptions, demand from top consumers the United States and China is a main driver of the current rally.

The US Department of Energy estimates that American demand will sag by just 200,000 barrels per day this year, less than one per cent of the 20.7 million BPD total.

Oil demand in China was up eight per cent in March from a year earlier, the fastest growth since 2006. The market cannot exactly do its thing in a country that subsidises fuel. Sinopec, the Chinese oil company, lost $2bn in the first quarter of this year from price controls.

While demand is the main driver now, supply disruptions do play a role?

Supply of crude from Nigeria, the world’s eighth-largest oil exporter, has been cut since February 2006 because of rebel attacks on the country’s oil industry. Oil companies and trading sources say 564,000 bpd of Nigerian production has stopped flowing into the market.

While there are concerns about supply disruption from Iran, another major producer, Iraq, is struggling to get its oil industry back on its feet after decades of wars, sanctions and underinvestment.

Exports of Kirkuk crude from northern Iraq are stabilising as the system recovers from technical problems that had mostly idled the pipeline since the US-led invasion of Iraq in March 2003.

Unexpected outages at US refineries have also drained inventories.

Surely high prices would prompt more investment in the sector?

You would think that $120 a barrel would spur oil companies to explore more. Even the most technically challenging and capital-intensive projects like the Canadian oil sands and deepwater Gulf of Mexico prospects require no more than $50 per barrel to be in the black.

But energy companies are a cautious lot. Only a decade ago oil plunged to $10 a barrel and companies are not yet willing to bet prices stay at current levels. BP, for one, still uses $60 as its price peg for evaluating new projects.

There is only so much capacity in the oil-finding business. Oilfield capital costs have doubled since 2005. Shortages of people, steel and machinery have doubled the cost of some oil sands projects in Canada.

In February 2007, ExxonMobil and Qatar Petroleum cancelled plans for a $7bn plant to convert methane into synthetic diesel in natural-gas-rich Qatar. According to the Middle East Economic Digest, a tonne of steel in Qatar costs $4,000 today, twice the price four months ago; cement is in severe shortage, while aggregate rock has tripled in price over five years.

Source: Al Jazeera and agencies 

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