The Sunday Telegraph: Oil is king – but for how much longer?

King Abdullah of Saudi Arabia. The soaring oil price was the perfect way to remind the West of his country’s importance

4 November 2007

As the price of crude hits new highs, Sylvia Pfeifer looks behind the scenes to discover where the market will end up once the speculative froth has washed away

Some of the City’s biggest hitters made their way to Buckingham Palace last Tuesday. The occasion: a state banquet in honour of King Abdullah of Saudi Arabia.

On the royal guest list were Jeroen van der Veer, the chief executive of oil giant Royal Dutch Shell, Sir Michael Bishop of BMI and Dick Olver of BAE Systems, the defence giant.

Business was off the agenda but the first state visit to Britain by a Saudi monarch in two decades was fortuitously timed. King Abdullah couldn’t have asked for a better way to remind the western world of his country’s importance than last week’s record oil price. Soaring demand and concerns over tight supplies sent the price of crude to an all-time high of over $96 a barrel.

Saudi Arabia is the world’s largest producer of oil, pumping several million barrels every day – barrels of crude that help power Bishop’s planes and will fuel the new BAE-made Eurofighter jets that Saudi Arabia has just bought from Britain.

The message will not have been lost on the Queen’s guests. With production growth from countries outside the Organisation of Petroleum Exporting Countries (Opec) slowing, the oil cartel, which accounts for some 40 per cent of the world’s production, holds enormous power in the market. Although there are doubts in some quarters about how much more oil Saudi Arabia can really pump, it is once again the swing producer.

advertisement”The big question is: what is Opec’s policy right now?” says Ian McCafferty, the chief economic adviser at the CBI and former head of macro-economics at BP. “What is their preferred price range for oil?”

McCafferty would be the first to admit that no one outside Opec really knows. Oil ministers will hold their next meeting later this month and the organisation is likely to come under pressure to pump more oil. But so far it seems to be resisting, instead blaming the record prices on speculative investors and geopolitical tensions.

“We are of course concerned about high oil prices,” Mohammed bin Dhaen Al Hamli, the president of Opec, said last week. But he added: “The market is increasingly driven by forces beyond Opec’s control.”

So what is really going on in the oil market? Opec’s view is by no means an isolated one. Many oil industry executives, including Shell’s van der Veer, believe that there is no fundamental reason why crude prices have hit their current levels. “There is a lot of psychology in the price,” he said in September.

Daniel Yergin, an industry veteran and the chairman of Cambridge Energy Research Associates, agrees. “Oil prices are becoming increasingly decoupled from the fundamentals of supply and demand,” he told a conference last week.

“With prices over $90 a barrel and strong anticipation of $100, the oil market is showing signs of high fever, stoked by fears of clashes in the Middle East and resulting disruptions of supply. A weakening dollar and anticipation of further weakness add further fuel to the fever.”

Last week’s decision by America’s Federal Reserve to cut interest rates is only expected to increase the amount of liquidity in the markets – money that will find its way into “hot” sectors such as oil and other commodities.

“The run-up in the oil price in the past two to three months is almost $30 a barrel,” says Fadel Gheit, a senior energy analyst at Oppenheimer, the New York investment boutique. “That is not all a reflection of demand growth. Demand growth is dropping in western Europe and the US because of the high price.”

What no one disputes is that the high prices and market volatility have attracted a new breed of oil speculator into the market in recent years. Investors, including hedge funds, pension funds and individuals, have all discovered that the real black gold is oil futures, where people trade the right to buy oil at a predetermined point in the future electronically. Experts reckon that oil trading has increased by almost 10 times in recent years as new players have flooded into the market.

Other players, such as Morgan Stanley, have gone one step further: employees at the US investment bank don’t just trade in futures but handle real barrels of oil, getting involved in transportation, storage and delivery. The bank even supplies jet fuel to United Airlines. Its position gives it a huge advantage over competitors as it can tell if the market is oversupplied or undersupplied.

The prospect of oil breaching the $100 a barrel mark has enticed even more speculators into the market in recent weeks.

“There are a lot of people coming into and out of the market. They all want to see if today is the day the oil price touches $100 a barrel. It’s one of those defining moments,” says Paul Newman, the managing director of commodities at Icap Energy.

While there is no question that speculators have contributed to the run-up in the price, others believe that people who blame them are ignoring just how tight supplies really are.

“Blaming the speculators is a lazy explanation. There is a genuine problem here,” says Paul Horsnell, the head of commodities research at Barclays Capital.

“It’s a situation where you have an extremely weak supply side from non-Opec countries, coupled with strong demand. These days people are prepared to pay more for early delivery. That shows you that it’s very much a supply-demand driven market.”

Recent supply and demand figures back up Horsnell’s view. The International Energy Agency has forecast that global demand will be 85.9m barrels of oil per day this year, rising to 88m next year. Supply, however, is forecast to rise from 85.2m to 85.6m barrels per day – leaving a growing shortfall over the next two years.

The voracious appetite of emerging countries, in particular China, has been the main driver behind the huge surge in demand. The Organisation for Economic Co-operation & Development (OECD), for example, estimates that China contributed more than 24 per cent of additional oil demand between 1995 and 2004.

Coupled with strong demand, oil reserves are low. Production from the West’s oil majors is also declining. Shell, BP and even Exxon, the world’s largest listed oil company, have all in recent weeks announced that their production numbers have dropped. On Thursday Exxon reported that its net income in the three months to the end of September had tumbled by 10 per cent to $9.4bn (£4.6bn) – the first time since 2002 that the company had suffered two consecutive quarterly falls in profits. The industry seems to have reached a critical point: despite soaring prices, its profits appear to have peaked as companies’ higher costs start to bite.

With western Europe about to head into the winter months, the supply situation could get worse before it gets better – which could propel the price of oil past the magical $100 mark. There is a growing consensus, however, that by next spring prices will be on a downward trend.

Goldman Sachs, which has been the most bullish Wall Street investment bank on the commodity, last week recommended clients to take profits, predicting that the price of oil could fall back to $80 a barrel by next April – although it admitted that, until then, anything could happen.

Says Oppenheimer’s Gheit: “It’s a bubble. The $64,000 question is, when will the bubble burst?”

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/11/04/ccoil104.xml

This website and sisters royaldutchshellgroup.com, shellnazihistory.com, royaldutchshell.website, johndonovan.website, and shellnews.net, are owned by John Donovan. There is also a Wikipedia segment.