Why oil is on the rise again

Prices have doubled since February, but that's probably not the end of it. Asia's recovery is igniting demand.

By Brian O'Keefe, senior editor

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NEW YORK (Fortune) -- Ask a group of oil analysts about the recent surge in crude costs and here's the consensus answer you'll get: Prices have run up too far, too fast and they aren't supported by the fundamentals.

Ask them about where prices will be two years from now, however, and the majority will offer this prediction: A lot higher.

"We're concerned about oil prices rising so rapidly in the near-term," says Hussein Allidina, head of commodities research at Morgan Stanley. "But the bet in the long-term is one way, and that's just up."

Oil shot past $70 a barrel last week, meaning the cost per barrel has doubled since hitting a low in mid-February. And the swiftness of that move has plenty of observers wondering if we're headed toward another period of even more dramatic price gains.

Among the oil insiders worried about such a scenario is Royal Dutch Shell CEO Jeroen van der Veer, a 38-year veteran of the energy giant, who is scheduled to retire June 30. "If the oil prices stay volatile I'm afraid there will be too much slowdown in investment," he said at an energy conference in Abu Dhabi in early June, according to Reuters, while reiterating that Shell would follow through on its spending plans for this year. "I think too low capacity means the next price spike is to come."

The last spike, of course, was a year ago at this time, when oil zoomed all the way up to $147 per barrel and Congress began holding hearings to discuss whether speculators were manipulating prices. Then a market correction that began in the middle of last summer was accelerated by the global financial crisis. Oil plunged to multi-year lows, with the price of benchmark West Texas Intermediate crude dropping under $35 in December and again in February.

To understand the odds of oil moving back above $100, it helps to first examine the reasons that the price has rebounded so strongly in recent weeks.

Much of the recent rally actually has nothing to do with the oil market's current supply-and-demand situation. The latest estimate from the International Energy Agency (IEA) projects that worldwide oil use will be almost 2.5 million barrels a day lower on average this year than in 2008. And despite the fact that OPEC has been cutting back on production since last September to boost prices, oil inventories around the world are still high compared to historical levels.

"Considering that supply seems ample and demand is weak, the fact that oil is going up looks kind of weird," says Adam Sieminski, chief energy economist at Deutsche Bank. "But those factors are being overwhelmed by a huge sigh of relief that we're not going to have the Great Depression. A lot of money is coming out of mattresses."

That inflow is lifting stocks and commodities alike. Research by Morgan Stanley found the correlation between crude oil prices and equities has recently been at a record high -- with both rising strongly on the hope that the economic cycle has already bottomed.

"Historically, equities have been a leading indicator of economic growth and commodities have been a coincident indicator," says Morgan Stanley's Allidina. "Right now you're seeing commodities and equities move up together as money comes back in at the same time."

Just as important, Morgan Stanley found that the inverse correlation between a weakening U.S. dollar and rising crude prices was also closing in on a record high. Because oil is priced in dollars, when the value of the dollar falls it makes oil cheaper in other currencies -- simultaneously boosting consumption outside the U.S. and motivating non-U.S. producers to raise prices to make up for the purchasing power they've lost in the currency conversion.

Concerns about the ballooning deficit in the U.S. have caused investors to begin fleeing the dollar. The U.S. dollar index, which measures the value of the greenback against six major world currencies, has dropped 9% since the beginning of March. As it falls, oil prices are rising. If it falls further, they'll rise higher.

But just how high oil prices go from here -- and how fast they get there -- will ultimately depend on the ability of producers to meet future demand. And any robust rebound in consumption is sure to put a strain on global supply.

The investment cutbacks warned about by Shell's Van der Veer only make that more likely. In its World Energy Outlook 2008, released last November, the IEA warned that production declines from existing supplies would keep the market tight and called for $26 trillion in new infrastructure spending worldwide over the next two decades. Right now, the opposite is happening. In May, the IEA said it expected a 21% drop in oil and gas investment budgets globally in 2009 compared to 2008, or nearly $100 billion less. A cautious OPEC has said that a lot of its member countries' new drilling projects remain on hold.

Meanwhile, there are signs that a demand recovery could be on the way in Asia. China's crude consumption averaged 7.6 million barrels per day in April, according to Allidina, the highest level on record, amid reports that the government was stockpiling commodities. Goldman Sachs was confident enough of a demand rebound to come out in early June with a price target of $85 a barrel for West Texas Intermediate crude by the end of 2009 and $95 by the end of 2010.

Deutsche Bank's Sieminski agrees that prices are going higher over time. "Our forecast has been that oil will be at $100 in 2015 and it could happen faster if the economy recovers," he says. Because oil is generally considered an "inelastic" commodity -- meaning it takes a big increase in price to produce a small change in demand -- the chances of a spike increase once supplies get tight.

"If you get close to the balance, prices can go haywire very quickly and there's very little that can be done about it," says Sieminski. "Something happens on the margin to put pressure on the market and instead of the price adjustment being gradual it's a step change. Last time gasoline had to go to $4 a gallon and crude had to go to $150 a barrel to rebalance things. And that's how we could get there again."

Let's hope we don't get there for a while. To top of page

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