Market Psychology

It's an understatement to say that this is the strangest oil market that anyone could have imagined a few years ago. It is poised on the verge of the psychologically important, but otherwise essentially meaningless $100/barrel mark, and every retreat toward $90 is greeted with a sigh of relief--never mind that $90/barrel is an extraordinarily high price in the absence of a major supply disruption. And that's what worries me most about approaching $100 on the basis of perceptions of a tight supply/demand balance this winter and a bit of speculative momentum. In the event of a truly serious supply problem, the launch pad from which prices would rocket upward would be higher than at any point in history, after adjusting for inflation.

There are many different ways to look at the price of oil. Economists tend to see it as the level at which supply and demand are balanced, moment by moment, but that can't really be true, except in a "long run" that we never seem to reach. As a result of government price controls, fuel taxes, and the buffering effect of refining margins, few of the world's consumers are exposed directly to the price of oil. And even where they are, as in the US, fuel demand is affected more by the value we derive from its use, and by structural limitations of lifestyles that can't be altered quickly, if at all. That has been made abundantly clear over a four-year period in which the retail price of gasoline in the US has doubled.

Others look at patterns of global demand growth and shifts in production capabilities, particularly the flattening of non-OPEC output, and conclude that today's price has largely been set by OPEC, through a combination of its capacity decisions and the periodic revisions to its output quotas. The recent rhetoric coming out of OPEC can be interpreted either as an effort to shift blame for this, or the response of a group of producers who are honestly as surprised as anyone else by the current price level. Perhaps it's some of both. Delegates at the OPEC summit in Saudi Arabia are suggesting that prices could reach $150/barrel and apparently discussing whether an alternative mechanism for pricing oil is required. And while they seem to have conveniently forgotten that much of the path leading to this position was determined by their own investment and capacity decisions over the past decade, they aren't wrong to worry about what could happen in a real squeeze, if mere tightness has brought us this far. In his column in yesterday's Washington Post, Robert Samuelson provided as clear a description of these circumstances and their implications as I have seen in a long time.

Then there's the view that the price is built up from a combination of supply and demand fundamentals plus a consensus on geopolitical risks. This has more credibility, particularly for those who follow the market's day-by-day gyrations, many of which do not reflect any actual change in production and consumption, but are responding to the news-driven perceptions and expectations of various players. But even if part of today's price reflects the potential of a collapse in Iraqi output, conflict with Iran, or sabotage elsewhere, the actual manifestation of such an event would take us much higher.

Whichever theory best explains the current situation, though, the consequences of an unexpected event removing two million barrels per day from an already tightly balanced market look equally disastrous, and that's what ought to concern us most, since $95 West Texas Intermediate--yielding average crude oil acquisition prices between $85-90/barrel--hasn't brought the global economy to a halt. As a speaker at this fall's Herold Pacesetter Conference noted, the price increase that would be required to "crush demand" by a couple of million barrels per day would not be just a few dollars; it might be truly astronomical.