Oil prices tethered to fundamentals

By Todd Hirsch Prices rose to nearly $US 78 per barrel for West Texas Intermediate crude on Thursday. But the big question on everyone's mind is: what's driving the price increase? And, is it sustainable?

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One big factor this week has been the depreciating US dollar. The greenback has slipped to the lowest level in more than a year, making dollar-denominated commodities like oil and gold more affordable for investors and consumers buying in other currencies (like euros or yen). The talking heads on the news will surely bring up "the fundamentals" – a phrase that's thrown around like confetti any time there's a question of commodity prices rising too high, or falling too low. Do the fundamentals support the price approaching $US 80? Probably not. Or at least, not yet. For one thing, the market fundamentals are determined by the cost of the marginal barrel of oil coming out of the ground. That is, how much does it cost producers to extract the last barrel that goes onto the market? Given the wide range of types of projects currently producing oil – from the mature, low-cost oil fields in the Middle East to the high-cost projects like off-shore oil and oil sands – experts estimate that the "marginal cost" is presently around $US 65-70 a barrel. Oil at nearly $US 80 is clearly getting out of that range. Secondly, traders seem to be anticipating that global consumption and demand is about to pick up quite a lot. But will it? For sure, the American economy has grown much more stable over the past several months, but it's still a long way from posting good, solid economic growth. Unemployment has not yet peaked in the US, and consumer confidence remains moribund. If demand for oil is about to take off, that demand isn't likely to come from the US. China? India? Certainly these are better bets for growing oil demand. But even here, it seems a bit overblown to suggest that these emerging economies can, on their own, lift oil prices from $33 to nearly $80 in less than a year. But the single most important reason why we shouldn't get too excited about rising oil prices this week is that this is simply the nature of commodity market movements. Prices regularly overshoot on the way up, and undershoot on the way down. Speculators do play a part, but they really just tend to exaggerate the trends the market is already displaying. If market forces of supply and demand are moving prices higher, speculators tend to push them much higher; and if market prices are moving lower, speculators will move them much lower. This is what we are seeing at the moment. Global supply and demand fundamentals are, indeed, moving prices gradually higher. But commodity traders are sniffing the trend, and are moving the market price ahead of itself. Think of global oil prices like a tether ball, where the position of the ball represents current price, and the position of the post represents the underlying global fundamentals. The ball will swing to-and-fro, and at times the size of those swings will be very dramatic (think of oil at $147 in July 2008!). The ball may never actually be at rest with the post, but the position of the ball will always tend to move back towards the position of the post. The ball is tethered to the post, just like oil prices are tethered to global supply and demand. It's very probable that the steep gains posted this week are being driven more by psychological factors (like market sentiment and speculation of economic recovery in the US). So some pull-back in oil prices could be expected in the days and weeks ahead. Yet, global supply and demand fundamentals do point towards gradually rising oil prices in the future. A depreciating US dollar, limited supply of low-cost oil, and an inevitable recovery in the global economy will bring prices higher. The tether ball may swing back and forth around the pole, but if the pole itself is moving – the ball has no choice but to gradually move with it.

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