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THE WALL STREET JOURNAL: The Road to $100 Oil – and Beyond

January 2, 2008 5:05 p.m.

Economists, Wall Street commodity traders and even seasoned energy executives were caught flatfooted by oil’s dizzying rise. Looking back, several factors came together at the same time to help oil shoot up roughly tenfold in less than a decade and briefly touch $100 today. Those factors are likely to stick around, perhaps pushing prices up further.

Western oil companies, though flush with cash, are finding fewer places to explore and drill for oil. Demand in China and the developing world has surged far more than people anticipated a decade ago and is driving oil markets.

Adding more volatility, oil is increasingly traded as an investment by financial players with little interest in owning the barrels. After years of internal friction, the Organization of Petroleum Exporting Countries has been more disciplined about keeping global inventories lean and prices buoyant.

The world’s ability to pump enough oil is being tested. “Demand has surged ahead and the industry has been playing an intense game of catch up,” says Daniel Yergin, chairman of Cambridge Energy Research Associates.

The Trends Ahead

Will the trends endure? Already, demand growth has slowed or stalled in some industrialized countries, including the U.S. If the U.S. falls into a recession this year, as some economists predict, that would tend to depress oil prices.

Nations such as China that have used subsidies to soften the blow for oil users are beginning to buckle and pass along price increases. That could also sap demand.

Says Didier Houssin, director of oil markets and emergency preparedness at the International Energy Agency in Paris: “The big question is, when will the demand reaction happen? We know it is coming, but what we don’t know is what price level will spark it. That is the ultimate crystal-ball question.”

On the supply side, high prices are encouraging companies to take more risks and pour money into finding oil in hard-to-reach places, such as deeper waters. In November, Brazilian oil company Petroleo Brasileiro SA announced the discovery of a giant new oil field estimated to contain five to eight billion barrels of oil. If that estimate is correct, it would be one of the largest finds in recent years.

But these finds take years to go from discovery to production. In the short term, financial investors who helped drive up oil prices are likely to continue swaying markets — and that can push the market in either direction, depending on traders’ short-term views.

Unlikely March

The march to $100 seemed unlikely 10 years ago. A glut of oil began to form in the first few weeks of 1998. Prices began to plunge as Western oil companies and OPEC members Saudi Arabia and Venezuela battled for market share. The Asian financial crisis weakened Asia’s crude demand. Meanwhile, that winter was one of the warmest on record in the Northern Hemisphere, lowering demand for heating oil. OPEC nations attempted to turn prices around by cutting production, but members cheated by pumping more than their allotment.

On Dec. 10, 1998, crude oil futures settled at a low point of $10.72 on the New York Mercantile Exchange.

The situation began to turn in early 1999. Hugo Chávez became president of Venezuela, one of the bigger cheaters, and promised better cooperation. In March 1999, OPEC ministers agreed to cut production again. Similar OPEC agreements had foundered in the past, as member nations greedily sent extra tankers sailing off in search of petrodollars. This time, the cartel stayed in sync. Prices began to climb and closed the year above $25.

Another emerging issue was the end of easy oil. The industry had found most of its giant fields in the decades after World War II. What was left was often in remote places with high extraction costs. Burned by price crashes in 1986 and 1998, the industry was wary of investing too heavily in new production. Wall Street penalized companies that were seen as overly aggressive. Big Western oil companies responded by being disciplined with their cash.

The thirst for oil was growing steadily. Demand in the U.S., by far the world’s largest consumer, grew by 2% to 3% a year in the late 1990s. Meanwhile, demand in developing nations took off and has remained strong despite rising prices. “The insensitivity of oil demand vis-a-vis prices has been startling,” says longtime oil observer John Olson, co-manager of Houston Energy Partners, a hedge fund affiliated with Sanders Morris Harris Group Inc.

Big Subsidies

Mr. Houssin, of the International Energy Agency, attributes some of this to massive subsidies that countries such as China, Saudi Arabia, Venezuela and Iran provide to keep domestic energy prices low. Strong economies in most parts of the world have also muffled the impact on consumers.

Even the Sept. 11, 2001, terrorist attacks caused only a minor dip in global demand. By the time a U.S.-led coalition invaded Iraq in March 2003, the world was consuming over 79 million barrels a day, up from 73 million barrels a day five years earlier. The invasion caused a dip in supply from one of the world’s biggest oil producers. By 2004, OPEC’s spare capacity, or the amount of additional oil it could deliver quickly if needed, shrank to the lowest level in a generation.

It was also the year that China truly came onto the world energy scene. With China’s economy surging, the demand for jet fuel nationwide jumped by nearly 50%, according to the China Aviation Oil Corp., then the country’s monopoly supplier of jet fuel. Facing electricity shortages, Chinese steel mills and other factories began sucking up diesel to power backup generators. In 2004, global demand shot up by an unexpected 2.8 million barrels a day, to 82.3 million barrels a day. Almost one-third of that growth was due to China alone. “That was the truly amazing year, and it will stand out for decades,” says Roger Diwan, an analyst at the Washington-based oil consulting firm PFC Energy.

At the same time, the oil-exporting Persian Gulf states were becoming substantial energy consumers themselves, as petrodollars turbocharged their economies.

The oil industry was unable to lift its output in lockstep. Some of the best oil fields are in places like the Middle East or Russia that don’t necessarily welcome Western investment. Many new fields that are being developed are offshore and take years to drill and connect to the pipeline grid. Also, the oil industry is in fierce competition for cranes, steel and experienced construction crews.

Trading Changes

While finding oil in the ground has been getting harder, it became a lot easier to buy oil on paper. The New York Mercantile Exchange started round-the-clock electronic trading of its main crude benchmark in September 2006 and improved access to previously restricted energy trading markets. Financial institutions created new vehicles for making bets on the price of oil without having to manage futures holdings.

All of this has helped attract a flood of new money that has transformed oil trading. The oil markets were once dominated by physical traders—firms that needed to take delivery of the crude oil to run through refineries or trade with partners. Most of the new market entrants have no interest in ever taking delivery of a barrel of oil.

The new money came from hedge funds seeking profits in sharp oil-price moves, pension funds seeking diversification and a hedge against inflation, and Wall Street commodity desks helping financial investors make sophisticated bets and risking their own capital.

The number of oil-futures bets outstanding on Nymex has quintupled since 2001. Because oil has been rising at the same time, the dollars at stake in the main oil-futures benchmark, not including options, rose from roughly $7 billion in 2001 to more than $145 billion, calculates Ben Dell, energy analyst at Sanford C. Bernstein & Co.

As this surge of money chased a slowly growing number of barrels, prices sprinted upwards. And there is little to indicate that the conditions created by these financial commodity traders will push prices down anytime soon.

Write to Russell Gold at [email protected], Neil King Jr. at [email protected] and Ann Davis at [email protected] and its sister websites,,,,, and are all owned by John Donovan. There is also a Wikipedia article.

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