Oil prices will leap again -- blame Russia

By Jim Jubak

Oil prices are in retreat. Oil producers are talking about cutting production. Projected oil demand has been revised downward.

So the oil crisis is over, right?

Wrong. I can clearly see the next oil supply crunch on the horizon. The next supply shock that will send oil prices shooting higher will come from Russia and arrive in 2008. In Russia, the forces are already clearly at work that will produce that spike.

Oil prices have fluctuated wildly in the past few months. The spot price of a barrel of benchmark West Texas Intermediate oil hit $74.41 on July 1. It's been down, down and down again since then, with the spot price of West Texas crude falling to $63.87 a barrel on Sept. 1 and $57.60 on Oct. 11.

That's a drop of 23% from July 1 to Oct. 11.

What's behind the plunge?

First, there has been a fall in current demand and a resurgence in current supply. Historic high prices cause some consumers of oil to get by on less. And at $75 a barrel, every last bit of supply that might have been shut down because it didn't pay comes back into production. Every month recently it seems that crude oil and gasoline inventories go up. An Oct. 12 report from the U.S. Department of Energy, for example, said U.S. commercial crude stocks rose 2.4 million barrels to 330.5 million barrels and gasoline stocks grew by 300,000 barrels to 215.4 million barrels.

Second, speculators have headed to the sidelines. On Oct. 11, the International Energy Agency lowered its projections for global oil-demand growth in 2007 to an increase of 1.45 million barrels a day. The drop in projected growth wasn't huge -- about 12% -- but if you're a speculator, it's the direction of the trend that counts. To keep oil prices climbing, projected oil-demand growth has to be going up, not down.

A relative peace

That's especially true because right now the oil-producing world seems a relatively peaceful place. Oh, sure, there's violence that on some days comes close to a civil war in Nigeria; Iran still faces possible sanctions from the United Nations because it persists in its plans to build nuclear weapons; Iraq seems about to move from unofficial to official civil war now that the parliament has given its approval to a future partition of the country; and Russia continues to threaten foreign oil companies.

But all this is pretty much business as usual -- it's all been going on for so long that the oil markets take it with a "ho" and a "hum." So what that Nigeria can't pump enough oil to meet its Organization of Petroleum Exporting Countries (OPEC) quota? The market has been living with Nigeria at 75% of production for months now, and the sky hasn't fallen. If you're a speculator, you need an upward trend in violence and fear to send oil prices up. "Normal" violence just won't do.

It's the flight of the speculators from the current market that has produced the huge price drop, just as it was a flood of cash from speculators that drove oil prices higher than the fundamentals justified to begin with. Beginning in 2004, when a huge 16% jump in oil demand from China shocked the oil markets, the trend was up over worries about supply and demand and fear of supply disruption.

The speculative "fear" premium now seems to be mostly out of oil prices. While the 23% drop from July 1 highs seems huge, recent oil prices have only returned to 2005 levels. The Oct. 11, 2006, spot price of $57.60 a barrel for West Texas Intermediate is virtually identical to the Nov. 1, 2005, price of $58.30 a barrel. Oil prices may still have further to fall, since market corrections almost always overshoot on the downside just as the market does to the upside in rallies, but we're approaching something like a fundamental price for oil.

But it's those oil fundamentals that made the speculators' job easy in the last year -- and are likely to do so again. The difference between oil supply and oil demand fell to a level well below the recent historical norm, so every minor threat of a supply disruption was amplified into a wave of fear that sent prices up by $1, $2, $5 a barrel.

The recent drop in oil prices has obscured the fact that this fundamental supply/demand condition hasn't changed. The International Energy Agency projects global oil demand at 86 million barrels a day. That's slightly above September 2006 levels of output at 85.4 million barrels a day. With some OPEC members cutting output recently (another 155,000 barrels a day in September), world oil supply will be able to meet demand in 2007, but not with a huge margin.

From Russia, with anxiety

It's that narrow margin between demand and supply that makes the oil market so responsive to any rumor of a potential supply disruption. And that brings me to Russia, where events are building, in my opinion, toward a scenario likely to spook the oil market again and give speculators new life.

Over the past few months, the Russian government has stepped up its campaign to give Russian companies, which in most cases has meant the state-controlled oil and gas company Gazprom, (OGZPY, news, msgs), controlling stakes in the development of Russian oil and gas resources. Nothing unreasonable about that, except that the Kremlin is trying to force Western oil companies with legal contracts to sell stakes in their projects to Gazprom.

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