Laws of supply and demand account for record oil prices

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CHICAGO – The dynamics of the world oil market are extremely complicated, but the laws of demand and supply still apply. And that’s why we’re seeing record prices for a barrel of crude.

Crude-oil futures closed at a record $72.17 Wednesday on the New York Mercantile Exchange, topping the record of $71.35 set just the day before.

The high cost of oil is cause for concern among businesses and consumers, and therefore has potential political ramifications, too. Rising energy can cascade through the economy, forcing prices higher for everything from bread and butter to surfboards and polyester pants – anything that requires petroleum.

For decades, demand for oil was largely determined by the health of the economies of North America, Europe and Japan. Recently the stunning run-up in the size, and energy appetite, of the economies of China and India has added to the cumulative global demand for energy, and in effect served to help support oil prices.

Even so, oil prices weakened in response to the U.S. economic recession of 2001, and excess supply drove oil prices well below $20 a barrel. Prices later firmed as the economy began to regain its footing – and then spiked in early 2003 when the U.S. launched its military invasion of Iraq.

Since then, the trend in energy prices has been up.

“The world oil price has risen rapidly and is very high today compared to the recent past primarily because demand growth has been very rapid and crude oil production capacity is constrained in the short run,” professor Severin Borenstein of the University of California-Berkeley’s Energy Institute told a Senate committee last month.

Production constraints remain among the key issues.

Unrest has crimped oil production in Nigeria for several months, while Hurricane Katrina knocked oil-producing platforms out of action along the Gulf Coast of the United States in late August. Iraq has thus far been unable to restore production to pre-invasion levels.

The latest price increases reflect concerns that Iran’s efforts to develop nuclear capabilities may cause an international response that will reduce Iran’s significant oil exports.

With oil supplies so short, “If we were to lose Iran’s exports of around 2 million barrels a day there’s no we can make up the loss,” Frank Verrastro, director of the Center for Strategic and International Studies energy program in Washington told Reuters.

Ironically, crude-oil prices are rising even though inventories are currently growing. That’s likely to continue for a few more weeks, experts say, because in an unusual but generally short-lived marketplace development known as “contango,” current oil prices are actually lower than futures for oil to be delivered later in the year. That situation provides an incentive for refiners and other buyers to build up stores of crude.

Crude futures “move in fits and starts, and this (runup) can end,” said Tom Kloza, chief oil analyst at Oil Price Information Service. The remainder of April and the first five days of May “will be the most hectic” period for oil prices, he said, noting that this is the period when refiners are switching from winter to summer blend.

Gasoline retail prices still are 10 to 30 cents a gallon short of catching up to wholesale price increases, he said.

The market “is always bipolar,” the analyst said. “We’re in the later stages of the manic phase here.” Kloza added that “this will be a year of extremes,” saying he expects sharply lower fuel prices in the year’s final quarter.

The runup raises the question of what, exactly, is the price of oil?

The usual stand-in is the price established by a Nymex derivative security that promises future delivery of a barrel of “light sweet” grade crude oil. While that contract is a reasonable indicator of oil-price trends, it’s pretty far from being a real-time number.

At Nymex, commodities traders make bets, in the form of futures contracts, on where they think oil prices are going to go. When news reports speak of “the price of oil,” they are referring to the settlement price of such contracts.

But the contracts rise and fall all day, however, blown this way and that by swirling rumors of unrest in Nigeria, a slowing economy in China and a thousand other factors that might affect supply or demand.

Of course, high-volume petroleum-product buyers such as petrochemical makers and airlines don’t buy their petroleum every day. Nor do they pay the Nymex price for a barrel. Such users buy under contracts that make their day-to-day energy costs much more stable.

But the disconnect between the futures price and the real market price only lasts for a while.

There’s just a brief lag between a rise in futures prices and a subsequent rise in energy costs, said Larry Young, senior trader at Infinity Brokerage Services in Chicago.

“If I’m paying a dollar more a barrel for crude, that price is going to be passed along when I refine the crude to turn it into gasoline,” he said.

Indeed, Young said Tuesday, the futures market currently “is saying the price of gas in May will be $2.21 a gallon wholesale. You can add anywhere from 30 cents to 50 cents retail.”

But, the trader added, “the retail gas station owner doesn’t wait until May. He reacts now. Before you go home you can see gas go up. That isn’t justified since the gas in the (station’s underground tank) is already paid for,” Young noted.

“But you definitely see a knee-jerk reaction to raise prices, and less of a knee-jerk reaction to lower them.”

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