The price of crude oil reflects many factors – both fundamental and speculative. Exactly how much of each is anyone’s guess. This last two weeks though has been interesting when looking at the price of oil and the factors at work behind that price. Let’s look at some.

On the fundamental side the first thing to consider is supply/demand tightness. On the one hand OPEC suggests that markets are well supplied but others believe that it is not. In fact, oil markets are very tight. According to the BP World Energy Review global production in 2006 was 81,663 thousand bpd and global consumption was 83,719 thousand bpd but global crude stocks were well above their five-year average. According to the EIA, in the first and second quarters of 2007, global oil supply and demand was as follows – Q1: supply 84.15mbpd, demand 85.58mbpd, Q2 – supply 84.47mbpd, demand 84.47mbpd. Currently, the IEA says that OPEC members are not pumping their full quotas. It identified 2.5 million barrels a day of spare capacity among 10 OPEC nations; roughly half of it is in Saudi Arabia. So looking at the numbers, the supply/demand picture is extremely tight although robust oil stocks are easing the situation. But, and this is a big big but, all oil isn’t the same and there are various types of crude oil that have to be factored in to this picture too. Light sweet crude supply is declining and gradually being replaced by heavy sour crude. All this seems to suggest that we have a real problem with supply and demand.

Let’s add in to that then refining capacity. With increasing amounts of heavy sour crude coming to market, looking simply at refining capacity isn’t really sufficient but to keep it quite simple let us simply understand that according to BP, refining capacity globally grew in 2006 for the first time since 2001 and, according to Lehman Brothers analysis, it is set to expand further such that by the beginning of the next decade, there will be overcapacity. On the other hand, almost all of that new capacity will be built outside of the USA and North American refinery utilization is also very high. In fact, refiners have been putting off unnecessary maintenance because it is so profitable to refine crude oil right now. The big picture is that refinery capacity is stretched at the moment and utilization rates are very high.

Under such a scenario, any event that appears to threaten supply or demand is bound to have an over exaggerated impact on price formation and there are plenty to consider including Iraq, Iran, events in Venezuela, Mexico, Nigeria and so on. Then there is the weather. Weather events can impact supply by knocking out production as in a Hurricane in the Gulf. Then there are unforeseen events, and with refineries delaying unnecessary maintenance the risk factors are simply increasing.

Who can do anything about any of this right now? Only OPEC but OPEC seems somewhat unwilling to officially increase quotas pointing fingers at other factors instead. One has to ask then if, in fact, OPEC is able to increase supply at all but according to the IEA they are. Nonetheless, and at the risk of running counter to my own past stance, it does appear a bit suspicious.

Let’s also just revisit the majors – another pet topic of mine these days. The majors continue to spend insufficient capital on E&P and instead, return money to shareholders and buy back stock. Again, one can take two views on this – either its good business to reward shareholders when profits are high and the cost to find has risen so much (and cynically, that this keeps the prospects of more oil coming to market lower and hence company profits higher) or there simply isn’t anything much left to find and so the majors are busy diversifying themselves for a non-oil future? Of course, the reality is that it is the smaller E&P and national oil companies that are doing the heavy lifting at the moment and spending the money to find new reserves. And they are finding new reserves and more importantly – new plays. A case in point is the new mega field discovery offshore Brazil which s both a new find and a new play with lots of promise.

The US Dollar factors in strongly too. As the Dollar has declined in value then the oil price has risen. At the time of writing here in the Czech Republic $5000 which just two-months ago was worth just slightly more than 100,000 Czech Crowns is now fetching only 89,000 Czech Crowns.

Higher prices have a demand response. That demand response has been slow coming but it appears that there is a consensus view developing that it is there as the IEA reduce their demand projections. When one looks at the global macro economics, there is a real danger arising of recession – especially in the US – and that ill impact future demand southwards too.

Finally, and there isn’t the space to cover everything here, there is the policy of China and India who are somewhat aggressively investing in energy including oil across the globe – even Canada’s oil sands. In effect, China and India are removing supply from the market through their activities.

Which leads us to the next set of factors – that of ‘speculation.’ Over the last 2-3 years not only has much more money entered markets but and more importantly, the cost and difficulty of trading energy markets has fallen dramatically. There are all kinds of new, liquid, exchange-based instruments to trade that simply were not there 5-years ago. Anyone can trade oil now through ETF’s and other vehicles. All of the banks and around 170 commodity hedge funds and an unknown number of proprietary trading firms are now involved in energy markets on an intra-day basis. And why shouldn’t they be?

What seems to get forgotten about these new traders however is that (at least in theory) they don’t care which way prices are moving because they can make money on up or down markets. The fact is of course is that many are actually ‘long bias’. What impact do they have on price formation? Well, opinions differ wildly which is why this last two weeks has been interesting.

A week or so ago, Lehman Brother’s pointed to the large open interest in oil markets suggesting that hot money was betting on $100 oil by the end of the month (effectively anyway). The interest was in options with an expiration date of last Friday. At the time, prices were moving inexorably towards the magic $100/bbl. However, a few days later, the IEA released its World Oil Outlook in which it stated that high prices had prompted it to cut its demand projections. Prices fell on the news. Certainly, the price moved back upwards again but $100 oil was not reached by Friday. Of course, there were other price signals during the period too. Fundamentals beat speculation last week and it always eventually will. Speculators speculate in both directions and are often simply playing the volatility. They are good for markets and increase liquidity and the number of trading counterparties available. They most certainly are not all powerful when it comes to directing price but admittedly they can help shape market sentiment and at any point in time, help to build a momentum and premium in prices (in either direction).

Meanwhile, Goldman Sachs stated last week that oil prices had traded in a range bound around $95/bbl in the past two weeks with a few short-lived attempts to rise to the $100/bbl mark and to fall below $90/bbl. Despite the limited change in levels, price volatility has been extremely high with average daily price moves of over $2.00/bbl, they said. They also said that “they are currently maintaining a $70/bbl assumption on 5-year forward WTI prices, but there is mounting evidence that the required levels could be higher.” They also pointed out that long-dated oil prices have increased considerably in recent weeks driving the rally in spot prices.

So what am I driving at here? Well, I didn’t suddenly become a peak oil fan and I have dealt with that fairy story on several other occasions. While it might be true to say that oil supply momentarily peaked, it was due to a lack of investment, an unreal sense of well being and a demand side surprise. Now, after 2-3 years of extra spending on E&P, there is at least one announcement of a new discovery everyday and some of them are very sizable. No, what I am suggesting is that we are stuck right now in a finite period of supply/demand tightness that means that prices will continue to be volatile and oil will continue to attract ‘speculators’ – though I prefer to call them ‘investors’.

In reality, as one polls the various views, analyses and opinions there is a rising consensus that prices are now too high and, at some point, there will be a correction. But that correction will take us to a price somewhere in the $75/bbl arena. This level will continue to support the marginal cost of alternative sources of oil and the increased finding cost of conventional oil and that will help insure that new supplies continue to come to market. But, this is only the start of high energy prices for there is yet no fossil fuel replacement and looking at the IEA forecasts, the future looks like supply tightness on and off for the rest of my – and your, life.

Article published as a European IssueAlert from UtiliPoint International, Inc. This newsletter is free and you can subscribe at http://www.utilipoint.com/european/subscribe.asp