Thursday, September 20, 2007

More Oil Price Details

The following from the WSJ gives additional perspective on the price of oil:

The weakening dollar is putting upward pressure on oil prices as other forces are already sending it up.

In addition to the main drivers of rising prices -- voracious demand by China and India and concern over supplies -- the interest-rate cut by the Federal Reserve this week could push the dollar lower and further lift oil.

A weaker greenback gives oil producers an extra incentive to drive prices higher: Oil is denominated in dollars on the global market, so producers are being paid for their output in less-valuable currency.

The further that crude pushes into new territory, the greater the risk that a price shock might damage the global economy. Oil costs can affect everything from transportation costs to consumer spending and retail sales.

Oil prices that rise too far could trigger a consumption decline either as a short-term correction or, some vocal bears warn, a more ominous repeat of the sharp rise in the late 1970s and steep subsequent fall that contributed to economic woes that reached into the early 1980s. Not likely, those price increases were significant on the order of two or three times the previous price. These increases will not be that dramatic in the short term unless there is a geopolitical problem.

While long-term oil forecasts are all over the map -- from $45 a barrel up to $100 -- a potent combination of conditions has laid the groundwork for the oil markets to now test what that new upper threshold may be. The only way for the price to drop to $45 is for OPEC to open up production and they do not have that much excess production. The other way is for the world to slide into a recession severe enough to decrease the price of oil.

Not only oil is affected. Most commodities are denominated in dollars, and commodity producers are often paid for in dollars, so commodities prices in general have risen as the dollar becomes less valuable.

Goldman Sachs Group Inc. commodity analysts now forecast year-end crude prices of $85, "with a high risk of a spike above $90" a barrel because of "anemic oil-supply growth."

The recent credit crunch also might imperil future supplies. Smaller oil and gas exploration companies are starting to report difficulty getting funding, says Subash Chandra, an analyst at Jefferies & Co.

Soaring prices aren't yet curbing global demand as much as might be expected -- at least not yet -- partly because the price is up considerably less when denominated in relatively stronger currencies. While oil prices have risen more than 160% in dollar terms since 2003, oil is up 97.5% in euros and 118% in Indian rupees, for example.

The Organization of Petroleum Exporting Countries has been recently lamenting the weaker dollar, which gives its members an incentive to keep a lid on production in hopes of raising prices. Earlier this year, Mohamed Bin Dhaen Al Hamli, OPEC's president, called the dollar's impact on its members' buying power "significant."

"I suspect that the dollar's depreciation is certainly an agent that is pushing oil prices up," says George Magnus, a senior economic adviser at UBS AG in London, while noting that supply-and-demand fundamentals guide long-term trends.

Crude's continuing climb leads some economists to fret about a vicious cycle in which expensive crude indirectly undermines the dollar further. Their argument: A portion of the dollars pouring into Persian Gulf countries are being converted into other, stronger currencies such as the euro as those countries gradually reduce their dollar holdings in foreign reserves.

"There's a desire not only to limit production but also to diversify away from dollars," says Richard Berner, an economist at Morgan Stanley.

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