THE WALL STREET JOURNAL: Oil Settles Above $70 a Barrel, Despite Inventories at 8-Year High

By BHUSHAN BAHREE in New York and ANN DAVIS in Houston
April 18, 2006; Page A1

Crude oil closed above $70 a barrel for the first time, highlighting a phenomenon reshaping the petroleum world: Investment flows into oil futures are supplanting nitty-gritty supply-and-demand data as prime drivers of prices.

In contrast to past bull markets in crude, this year's run-up has occurred even though oil inventories in the U.S., the world's largest market, have swelled to their highest levels in nearly eight years.

Yesterday on the New York Mercantile Exchange, U.S. benchmark oil for May delivery settled at a record of $70.40 a barrel, up $1.08 a barrel, or 1.56%. It traded as high as $70.45 late in the session, 40 cents shy of the Nymex intraday record of $70.85, set Aug. 30 last year, as Hurricane Katrina ravaged production and refining facilities in the Gulf of Mexico. The inflation-adjusted record oil price, set April 1980, equates to $97.21 in February 2006 dollars. Year-to-date, oil is up 15%.

Oil at $70 a barrel, if sustained, is likely to damp U.S. consumer spending, which is already coping with the impact of higher interest rates and a cooling housing market. However, the effect may not be severe because, while oil prices are still rising, the impact of much of the three-year bull market for crude oil — up to about $60 a barrel — has been absorbed already.

Federal Reserve officials have acknowledged energy prices remain a risk to their generally positive outlook for economic growth, but do not yet appear worried. Higher oil prices could put upward pressure on inflation, but so far, the signs are scant that pricier oil to date has led to broad price increases for other goods and services.

“The rise in energy prices has apparently had only a limited negative effect on the national economy,” Federal Reserve governor Donald Kohn said in a speech last week.

Industry analysts and economists have said that given the limits on additional new supply, only slower economic growth — and thus lower demand for oil — can reverse the upward trend of oil prices. Still, says Adam Sieminski, oil strategist at Deutsche Bank, “The shock value of $70-plus crude oil and nearly $3 [a gallon] gasoline could lead to an erosion in demand.”

The answer to the puzzle posed by rising prices and inventories, industry analysts say, lies not only in supply constraints such as the war in Iraq and civil unrest in Nigeria and the broad upswing in demand caused by the industrialization of China and India. Increasingly, they say, prices also are being guided by a continuing rush of investor funds into oil markets. Institutional money managers are holding between $100 billion and $120 billion in commodities investments, at least double the amount three years ago and up from $6 billion in 1999, says Barclays Capital, the securities unit of Barclays PLC.

The flow of money into oil, analysts say, has been prompted by a spreading belief that demand for oil will continue to rise with global economic activity as supply tightens under the influence of several factors — among them, the West's escalating nuclear standoff with Iran; growing political violence in oil-rich Nigeria; and more broadly, steadily growing global economic activity. The three-year bull run in oil has been underpinned by strong global demand for fuel coupled with a prolonged shortage of spare capacity to pump and refine crude.

“What's been happening since 2004 is very high prices without record-low stocks,” says Jan Stuart, global oil economist at UBS Securities. “The relationship between U.S. inventory levels and prices has been shredded, has become irrelevant.”

It remains to be seen whether this belief in a paradigm shift that permanently buoys oil prices will stand the test of time. Not everyone agrees that financial flows have trumped the importance of inventories, and oil traders still anxiously await each weekly inventory report from the U.S. Energy Department.

Yesterday's oil-price rise came after the U.S. Energy Department reported last week that commercial crude-oil inventories had risen to 346 million barrels, the highest level since May 29, 1998. But gasoline inventories dropped.

On Nymex yesterday, the price of a gallon of gasoline rose 6.18 cents, or 2.93%, to $2.1697. Retail gasoline prices typically run 65 to 70 cents over the wholesale price. The average retail price of regular gasoline rose to $2.78 a gallon this week, according to the Energy Information Administration, up 10 cents from last week and up about 55 cents from a year earlier.

One reason for the anomaly of rising oil inventories amid rising prices is temporary. Even as crude stockpiles have swelled, U.S. inventories of gasoline have fallen as refiners have shut down operations to perform maintenance and prepare to meet new government-mandated fuel formulas. Higher gasoline prices give a further lift to crude prices because refiners are willing to pay more for low-sulfur, gasoline-rich varieties of oil, such as the U.S. benchmark light sweet crude.

American oil inventories remain the best gauge of supply-and-demand trends, albeit an imperfect one. The U.S. is the world's largest oil market, accounting for nearly a quarter of world demand of more than 84 million barrels a day. Analysts note that inventories in the rest of the world increasingly matter as China and India, two big and growing economies, join Europe and Japan as major users of oil. The problem is that no other large economy reports oil data as promptly and comprehensively as the U.S., which comes out with numbers weekly. Other countries publish data months old.

Analysts say that behind the flush U.S. inventories lies a new trend born of the extended run-up in oil prices. Refiners of crude, who once sought to hold lean inventories, and traders, many of whom prefer to flip paper rather than buy and hold actual oil, are now grabbing more than they used to.

Since early 2005, the crude-oil market is in what traders call “contango,” meaning futures contracts for a given product are priced higher than that same good for near-term delivery. The price of oil to be delivered four months from now is about $3 more than oil to be delivered next month.

In short, it pays for refiners and other oil-market players to buy and hold oil now to sell it down the road. Making that trading opportunity possible, says Colorado-based oil analyst Philip K. Verleger, is the huge volume of new buyers on the other side: investors who he estimates have put more than $60 billion into U.S. crude-oil futures since 2004.

“Suddenly, the best use of funds by a company like Valero \[Energy Corp.]”, the largest independent U.S. refiner, “is putting money into tanks for more crude rather than investing in facility upgrades,” Mr. Verleger said in a recent report.

Indeed, San Antonio-based Valero has been operating with its crude tanks full since the start of the year. When the market is in contango, “you tend to operate at the top of your tanks,” says Bob Beadle, Valero's senior vice president in charge of crude oil, supply and trading. Mr. Beadle estimates that in the U.S., the difference between the industry operating at full tanks and at minimum operating levels amounts to as much as 75 million barrels of oil, or about three days of supply.

The last time U.S. inventories were at today's levels, in 1998, the market was about to crash. By the end of 1998, prices fell below $11 a barrel from an average $18.32 in December 1997.

A crash looks unlikely now, both because supplies remain tight and because of the large volumes of money that investors are pouring into oil markets. Money managers such as pension funds are investing in commodities to diversify away from stocks and bonds, and appear willing to buy commodities through passive, index-linked investments at ever-higher prices. But if the investment tide turns, prices could fall quickly.

During their meeting in Vienna last month, officials from the Organization of Petroleum Exporting Countries expressed concern about rising inventories and the growing role of financial players. Their fear: Money flows could reverse on the proverbial dime, while any move by the cartel to reduce supply would take months to affect markets.

OPEC also fears a return to “backwardation” — the opposite of contango — with near-term prices higher than long-term contracts. Such a flip-flop could prompt speculative buyers to dump inventories; prices could quickly drop $20 a barrel or more, OPEC officials said.

“More and more people are going to recognize that the fundamentals just aren't there to support these prices,” said John Gault, an adviser to the energy industry with Geneva-based firm Nalcosa.

Ranged against that fundamental view are the buy-and-hold institutional investors who have been pouring money into oil markets as a long-term asset. Unlike hedge funds, which are as likely to bet on oil's decline as on its rise, these passive investors don't short markets and tend to stay with their investment decisions for longer periods, according to Mr. Verleger, the Colorado-based consultant.

Write to Bhushan Bahree at [email protected] and Ann Davis at [email protected]

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