The Comedy of Oil Price Politics

RelevanceThree weeks ago we witnessed the comedy of politicians in Congress (the Senate Judiciary Committee – who else?) hauling executives from the majors to stand to account. They duly handed out a very public whipping over high oil prices. This ritual takes place every time we enter a period of high prices, and the story line goes something like this: oil prices increase to high levels; there is public outcry over gasoline prices; politicians feel the need to be seen to do something; oil executives face a barrage of seemingly tough questions by uninformed politicians who then send them home with their tales between their legs, but take little action. Anyone seeking insight into why the world is facing record high oil prices should turn to BP’s Tony Hayward, who published a very enlightening article in yesterday’s FT.

Analysis: The Hayward article cuts through the politics to provide us with a clear understanding of the realities of today’s oil market, along with some suggestions as to what can be done. It can be found at and I summarize it here, along with a few of my own thoughts. 

Hayward debunks the myth that current high oil prices are caused by speculators and reminds us that instead they are caused by supply and demand fundamentals. This is a view shared by Goldman Sachs, who recently pointed out that if speculators were hoarding oil in anticipation of yet higher oil prices then we should see rising inventories. And yet the opposite is true, as inventories are currently low. Others point out that speculators in oil price do so through the futures and other derivatives markets. These contracts hardly ever result in the physical delivery of oil and are instead a bet on changes in the price of oil. The cost of a bet on the future direction of the oil price is therefore determined by the supply – demand equilibrium of these paper contracts.

He reminds us that robust increases on the demand side have come from China, India and many oil producing countries (who are now consuming more through downstream investments). These have only partially been offset by falls in demand from the traditional large consumers (such as the U.S. and E.U.). Supply, on the other hand, has struggled to keep up. OPEC production fell by 350mbd in 2007, and now Russian output has started to decline. New supplies are from much more technically challenging areas such as Canadian oil sands, the Arctic and ultra deep water GOM. Resource nationalism is restricting the ability of the majors and other investors to bring onstream new supplies in a timely fashion.

The world has plenty of oil, in fact R/P ratios have held up very well over the last few years. The key is to develop these reserves to increase supplies, and here the challenge is often political.

Hayward makes a plea for a market solution to the current high oil prices. On a day to day basis, the oil markets function very well. A highly developed market, with transparent trading leads to market determined prices. The big short term influence on price is OPEC, and even it can see the inherent danger of very high prices.

But it takes years for new supplies to come on stream and for conservation and energy substitution efforts to take effect. And unfortunately the long term market for oil is anything but free. On the supply side resource nationalism and government policy (e.g. the U.S. restricting access to its continental shelf, Arctic and Rockies) interfere with the workings of a free market. On the demand side many nations in the world heavily subsidize fuel costs to the consumer.

These irritable politicians would be well advised to start looking closer to home for solutions to the high oil price problem.


13 June 2008


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