Why Is Oil So Pricey?

For the last several months, almost everyone has been asking why gasoline prices are so high. The standard answers often fail to satisfy, and far too many people see signs of a conspiracy. I've devoted a fair amount of space to this issue, but I've largely ignored the more important, fundamental question of why oil prices are so high. Oil prices remain the largest single component of retail gasoline prices, accounting for about 54% of the pump price, and most of those who follow oil are focused on the factors that could move its price up or down, rather than looking at its absolute price level. Why should oil be trading at $70 today, instead of $30 or $40? This question ought to be of great interest to the public and to government officials, and especially to those developing or investing in alternative energy.

Reviewing the long history of oil prices provides some interesting insights. Prior to 1973, oil prices were quite stable, which meant they were trending downward in real terms. From 1985 to 2002, nominal oil prices averaged $21/barrel, and with the exception of a few spikes, such as the Gulf War, real oil prices were generally falling. The overall pattern reflects sharp upward discontinuities, followed by a gradual decay in prices until the next spike. This history includes periods with all sorts of economic, geopolitical, and market conditions. To understand why the oil price is so high, we need to ask what is different today, compared to previous, similar periods when it was lower. Consider some of the factors that are usually trotted out to explain high current oil prices:

Asia's growth - India and China are growing rapidly, straining global oil supplies and pushing prices higher. But is this growth unprecedented? Since 1997 China's oil demand has grown at an average rate of 7% per year, based on US Department of Energy data. Over the last five years, that has added roughly 500,000 barrels per day (bpd) to global oil consumption. But that increment is still only 0.6% of total global consumption of 84 million bpd. From 1960-1970 oil demand in the OECD--essentially the US, Western Europe and Japan--grew by over 8% per year, driving total global demand up by around 6% per year for a decade, during which total consumption more than doubled. Over that entire period, when prices weren't influenced by OPEC, but guided by the Texas Railroad Commission, they were steady in nominal terms and falling when converted to 2005 dollars.

Falling spare capacity - Many analysts suggest that the decade's global economic growth has outpaced the ability of oil producers to expand spare capacity, and the resulting narrowed gap between supply and demand has pushed prices higher. There's no question that global oil capacity has been strained, particularly in 2004 and 2005. It's hard to gauge spare capacity reliably, but it was clear that Saudi Arabia, the world's swing producer, had to dig deeper into less desirable, heavier grades of oil to meet the call on its output. But one of the best proxies for the interaction between supply and demand, inventory, tells a different story. Total OECD oil inventories--which include strategic reserves--have grown by 10% since 2002, with US commercial crude oil inventories currently 9% above their 10-year average. By itself, this fact doesn't suggest that crude is overpriced, but it certainly doesn't justify today's price level, either.

High geopolitical and other risks - Al Qaeda, war in Iraq, unrest in West Africa, climate change, hurricanes: the last six years have been a compendium of nearly every bad thing that can happen to affect the price of oil, and the idea of a high "risk premium" on oil is widely accepted. But how high should it be? What did previous events like this do to the price of oil? Consider the case of the Gulf War, when Iraq invaded Kuwait and threatened Saudi Arabia. From the time Saddam's forces crossed into Kuwait in August 1990 until the coalition air campaign began in January 1991, the price of West Texas Intermediate crude on the NYMEX rose by about 50% from the average of the preceding 12 months. (Once the shooting started, the price plummeted back to the low $20s.) On a comparable percentage basis, the Iraq War, which has had a smaller impact on actual oil production than the Gulf War, might thus account for about $15/barrel of the current price. It's hard to imagine all the other risks doubling that figure.

That brings us at last to the question of whether speculation might account for the remainder of the doubling of oil prices that has occurred since 2002. This is certainly a relatively new factor in the oil markets, compared to the 148-year history of the commodity. The number of players in the futures, options and oil derivatives market, compared to even a decade ago, has exploded. "Open interest" on the New York Mercantile Exchange, a measure of the scale of trading, has more than doubled since 1999, when it stood at 638 million barrels of crude oil. As of Friday's session, aggregate open interest across all crude oil contracts going out to 2012 was just under 1.5 billion barrels. But does that mean that speculators are manipulating the price of oil, as some have alleged? I think there's a different explanation that looks at the nature of these markets, rather than the intentions of their participants.

Oil futures have a basic similarity to equities. Both reflect the underlying value of the thing to which they are linked--barrels of oil in one case, the fortunes of a company in the other--but both also have an independent existence. Oil commodity futures are in demand as financial instruments in a different way than when they were used primarily as a way for refiners and distributors to manage the risk on their physical market activities. As that demand grows--as more individuals, companies, and hedge funds want to participate in the oil market, without a link to any physical supply or demand for the commodity--then the price of these instruments ought to rise, in tandem. But with the price of most physical oil pegged to a futures market, whether for WTI or European Brent crude, that demand can influence the physical market, as well, without changing the real supply or demand by one barrel.

Anyone who has traded oil knows that the physical market needn't move in lock step with the futures market. Differentials for physical oil versus futures wax and wane, depending on a variety of factors, and if the only thing going on were long-term inflation of oil futures by financial demand, you'd expect the discounts for real grades of oil to widen versus the futures to compensate. But those differentials aren't set in a vacuum, without reference to previous prices. You don't wipe out the entire price history of the commodity and arrive at the price from scratch every day.

How much of an influence could the expansion of market participation have? I honestly don't know, but the shortcomings of the other explanations that I discussed above at least suggest that we're missing something important. Frankly, I find this a much more interesting question than many of those that are being asked about gasoline prices in the Congress and elsewhere. Rather than wondering if the market is being manipulated by oil companies or hedge funds, we ought to be analyzing the broader impact of the enormous increase of investor interest in oil price instruments on the cost of real oil to the economy. If anyone has run across a study looking at that, I'd love to see it.