Beep! Beep!
You know that cartoon? The one where Wile E. Coyote runs off a cliff but doesn’t fall … at least for the few seconds before realizing there’s nothing holding him up? I think of that scene when looking at today’s oil prices. At an average price of $41/barrel during July, West Texas Intermediate — an important industry benchmark — posted a record high before advancing to $44/barrel during the first week of August.
Without a doubt, this is taking a toll on the economy. Even before this latest rise, we estimate that rising energy prices over the first half of 2004 reduced real disposable income by $35 billion. Of course, some of this loss to consumers ends up being a gain to energy producers, but with imports accounting for ever-larger shares of U.S. energy consumed, about half that amount will end up abroad.
For a while, rising oil prices seemed justified by the fundamentals: supply and demand. In July of 2003, for example, the International Energy Agency predicted global oil demand would rise a modest 1.3% for the year, with another small gain of 1.3% coming in 2004. Last month, however, that same organization estimated last year’s actual gain at 2.2%, while its prediction for this year’s gain more than doubled, to a robust 3.2%. The upward revisions, of course, reflect the fact that the global economic recovery surpassed all but the most optimistic expectations. And with actual oil demand exceeding expectations, scarcity prevailed. Stockpiles fell below normal, where they remained until recently.
Over the past few months, however, things have changed. As one might expect, high prices motivate suppliers to increase output, and they’ve eagerly obliged. Supply has been running ahead of demand since this past spring, as evidenced by rising oil stockpiles. Moreover, the conventional wisdom among energy analysts is that this situation will get better as we move forward in time. According to a detailed analysis of “oil field mega projects” in the January issue of Petroleum Review: “The conclusion to be drawn appears to be that for the next four years a flood of new production is set to hit the market.”
Yet if fundamental developments seem so favorable for oil prices to decline, why might we be observing the opposite? The answer: speculation. According to the Commodity Futures Trading Corporation, which tracks futures and option trading for commercial (i.e., hedging) and other (i.e., speculative) purposes, the net long position of speculative accounts was a record high this March. Even after winding down somewhat, the net long speculative position remained very high by historical standards at the end of July.
War-related sabotage in Iraq and Nigeria, slow recovery from labor strife in Venezuela, and possibly suspended exports from a major Russian producer all contribute to this risk premium. Commodity investing has also caught on as an asset class with investors who view the run-up in prices over the past two years as a sustainable trend rather than a transitory adjustment.
As with all speculative developments however, they eventually reverse course in the face of contrary fundamentals. And though it’s hard to predict exactly how long Mr. Coyote will hang there, he always falls in the end.
