Oil Prices Are Poised on a Political "Knife's Edge"

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Oil Prices Are Poised on a Political "Knife

As explained in the June 2006 Trends issue, the price of oil is not up because the world is running out of oil. It’s fair to say that new technologies are adding to the world’s known oil reserves faster than we’re consuming them.

And, if we just consider traditional proven reserves, OPEC is sitting on 902 billion barrels of oil. In 2005, despite the global economic boom, the entire world only consumed about 30 billion barrels. In other words, OPEC could satisfy worldwide oil demand at our present rate of consumption for the next three decades without doing any further exploration.

And, according to a report released by the Joint Economic Committee of the U.S. Congress, this counts only the 11 OPEC nations.1 It ignores all the non-OPEC oil-producing nations in the world. Consider the fact that Canada’s reserves could supply all of the world’s petroleum needs for four years,2 while Russia’s could do so for three years.

So, if there is plenty of oil in the ground, does some sudden increase in the cost of producing the oil account for the dramatic increase since 2004? Hardly! When the Joint Economic Committee released its report in late 2005, the committee’s chairman, Jim Saxton, observed that it costs just $5 a barrel to produce oil in Saudi Arabia.

BusinessWeek3 quoted Tim Evans, senior energy analyst at International Financing Review as saying that the average cost of getting oil out of the ground runs from $7 to $9 a barrel. So “rounding that number up” to a generous $10 a barrel and doubling the price, you get a price of $20 per barrel — which, coincidently, was close to the average inflation-adjusted market price between 1986 and 2003.

So, how do we come up with the extra $30 to $50 in price that the market has placed on a barrel of oil in 2006? What formula do traders use to arrive at oil that costs $70, or more, a barrel?

The answer is simple. They use a fear factor. There is no rational formula. The world price of oil is set by buyers and sellers in commodities markets. Since the months leading up to the invasion of Iraq, consumers of oil have been building inventories to protect themselves against such a disruption. At the same time, speculators in these markets have been betting that a sizeable disruption in supply will occur. They’ve been buying into the oil futures market, driving up prices. At the same time, they’ve been looking ahead to a crisis that disrupts the supply of oil for a few weeks or longer, permitting them to unload their positions when the price briefly tops $100 a barrel...

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