Why Oil Price Kept Rising Before Clinton Intervened With The SPR Move.

*** Oil Companies Have Realised They Cannot Be At The Mercy Of The Spot Tanker Market, Seeing Their Hardened Cents-Per-Barrel Being Wiped Out By Dollar-Per-Barrel Freight Increases; A More Dynamic Forward Trading In Freight Derivatives Is Foreseen

*** Before Clinton Made The Move, The Crude Oil Price Had A Speculative Premium Of $8/Barrel

*** If The Winter Is Mild And Supplies Rise, The Price Will Be Under A Penalty; The Longer You Have This Discount, The More It Will Be Part Of The Fundamental

Five factors kept world crude oil prices high before President Clinton said on Sept. 23 he had ordered a release of supplies from the 571m-barrel US Strategic Petroleum Reserve (SPR). Clinton's announcement that 1m b/d of SPR crude will be released for 30 days led to a fall in prices from Sept. 25. These factors merit examination:

1. World demand for oil has been strong, despite a steady rise in oil prices since March 1999. In the US, where the fuel tax is not so high, consumers will continue to use as much energy or industrial feedstock as they will need, now that cost of oil will go down.

In the European Union - where the fuel tax could be as high as the UK government's US$140-take out of a barrel of crude oil, compared to OPEC's recent average take of about $30/barrel - demand has been strong despite the unrest in most EU countries (see OMT 12, pages 3-4). In Asia the strength of oil demand was reflected recently in narrowing differentials between the spot prices of Brent and Dubai: $0.68-1.95/barrel, compared to $6.55 on Sept 7.

OPEC's website - at www.opec.org - explains in detail how fuels are being taxed by rich governments in the EU and the other parts of the world. In the UK, where the fuel tax is the highest in Europe, the system works in such a way that, whenever the price of mogas goes up, the tax goes up even more.

2. The futures markets have been in steep backwardation, with prompt delivery (spot) and near-term prices higher than longer-term prices, which made the oil refiners reluctant to increase stocks.

In fact hedging in paper oil, a financial exercise once introduced as a "solution" to the risks of price volatility, is the first obstacle to price stability. The backwardation has further squeezed supplies of products like gasoline and heating oil.

Conversely, a contango (i.e., when forward prices are higher than spot and near-term prices) will raise inventories as oil refiners will be encouraged to buy more crudes for storage and to store more products for future profit opportunities. Both backwardations and contangos make sure prices are not stable.

3. With the futures markets driven by psychology and not by supply/demand fundamentals, the role of speculators in both futures markets and spot trading is the third most important factor. This helped Oct. WTI rise above $37.80/b on Sept. 20, when Nov. Brent at IPE hovered around $34.50. With oil prices having begun to fall on Sept. 25, and as the EU states later considered releasing oil from their emergency reserves, the speculators were poised to talk prices further down.

OPEC President Ali Rodriguez said on Sept. 19 speculation was adding $8 to the price a barrel of crude oil could cost, based on supply and demand. After prices began to fall on Sept. 25, he and other OPEC ministers expressed concern that, if the winter proves to be mild, downward speculation could lead to a collapse in the value of oil as in 1998 and early 1999.

4. The capacity shortage in the US oil refining sector in recent months was worsened by stricter environmental rules in important states of the US. As a result, a shortage of reformulated gasoline in the US could not be covered by surplus gasolines produced elsewhere because they did not meet US specifications. There is also a shortage of refining capacity in the EU but this has not been as serious as in the US.

There is no major difference between EU gasoil and US heating oil specifications. There could be a heating oil glut in the US if the winter is mild and/or if the Clinton administration has released too much of this fuel out of its forthcoming 2m barrel heating oil reserve for the US north-east. Together with repeated releases of crude oil from the American SPR, a contango in the futures markets could be quite deep - if the winter turns out to be milder than anticipated and the EU has released reserves.

5. The rising cost of oil shipping, because of a shortage of ocean-going tankers, has been the next factor. The cost of moving crude oil from the Persian Gulf to Singapore, one of the busiest trade routes, has risen more than fivefold in the past year, adding up to $2.1m to the cost of hiring a tanker.

High global demand for oil has left the world's 430 supertankers struggling to meet orders for their services. The tanker market has risen to a 25-year peak and now accounts for about 8% of crude oil prices. The shortage of tankers is worsened by the age of the vessels at a time when oil firms are demanding safer ships to protect against expensive accidents, such as the sinking of the Erika off Brittany in Dec. 1999.

A sixth factor is the shortage of oil production capacity worldwide. In OPEC only Saudi Arabia has any significant spare capacity but some of this would take months of de-mothballing work to become available. Abu Dhabi, Algeria and Qatar have had little spare capacity, but they have been overproducing their quotas in recent weeks. Spare capacities in the non-OPEC countries are negligible.

Iraq would have almost 1m b/d of spare capacity if it gets equipment and spare parts to improve its production system and expand its export facilities. But Iraq's leader, Saddam Hussein, would rather cut than increase oil exports in his three-phase power game with the US (see News Service of APS Diplomat's issue No. 13).

The Prospects Ahead: Clinton, with the Democratic Party in the background, is determined to see oil prices come down and the American oil consumers feel good before the Nov. 7 US presidential elections. Energy Secretary Bill Richardson said on Sept. 24 there could be another release from the SPR if it is necessary and a decision would be taken before Nov. 7. With this and other measures announced by Clinton on Sept. 23, such as an unprecedented $400m aid fund to help low income people afford heating oil in winter and an easing of environmental rules on fuel imports, the markets might switch to contango.

When the futures markets are in contango refiners raise their stocks. When markets are in deep contango, as in 1998, oil prices collapse. Just as there is no ceiling above which prices cannot rise, there is no floor below which futures prices cannot fall in a contango say by next April or before.

As their summit opened in Caracas on Sept. 27, some OPEC leaders said Clinton's moves amounted to interference in the market.

Were OPEC Members Greedy? OPEC oil ministers say they have had no choice but to be cautious in raising production. Rodriguez said after OPEC's Sept. 10-11 meeting in Vienna: "We cannot act now as we did in Jakarta" in November 1997, when a 2m b/d output increase led to a collapse of oil prices.