Why the Price of Oil Is $95/barrel - Econ 101 Version

The following article from Reuters is a good summary of why the price of oil is as high as it is. The laws of supply and demand apply but this market has a lot of moving parts that are usually not considered when discussing energy. For example, as the conduit money flowed out of that market some it flowed into commodities helping to push up the price. Text in bold is my emphasis.

U.S. oil hit a record high $96.24 a barrel on Nov. 1 after a steeper-than-expected drop in U.S. crude oil stocks and a further cut in U.S. interest rates. Strong demand for crude and a weak dollar have fuelled the rally from a dip below $50 at the start of the year.Adjusted for inflation, oil is still below the $101.70 peak hit in April 1980, according to the International Energy Agency,a year after the Iranian revolution.

The fall in the value of the dollar against other major currencies has helped drive buying across commodities as investors view dollar assets as relatively cheap. It has also reduced the purchasing power of OPEC's revenues and increased the purchasing power of some non-dollar consumers. OPEC oil ministers have noted that although prices are rising to record nominal levels, inflation and the dollar have softened the impact. Some analysts say investors have been using oil as a hedge against the weaker dollar.

Since the Federal Reserve cut U.S. interest rates in mid-August and central banks pumped billions of dollars into financial markets to ease a credit crunch, oil prices have surged close to 40 percent and gold has risen 20 percent. Investment flows from pension and hedge funds into commodities including oil have boomed, as has speculative trading. At the same time, the credit crunch has brought some other markets, notably the U.S. asset-backed commercial paper market, to a virtual standstill. In the United States, the size of the asset-backed commercial paper market has fallen for 11 consecutive weeks, to$883.7 billion this week from a peak of $1.17 trillion at the end of July, according to data from the Federal Reserve. In Europe, according to analysts at BNP Paribas, the market shrunk to $192 billion at the end of September from $297 billion at the end of July. Some of that money has found its way into energy and commodities.

While previous price spikes have been triggered by supply disruptions, demand from top consumers the United States and China is the main driver of the current rally. Global demand growth has slowed after a surge in 2004 but is still rising and higher prices have so far had a very limited effect on economic growth. Analysts say the world is coping well with high nominal prices because, adjusted for exchange rates and inflation, they are lower than during previous price spikes and some economies have become less energy intensive.

The Organization of the Petroleum Exporting Countries,source of more than a third of the world's oil, started to reduce oil output in late 2006 to stem a fall in prices. Fewer OPEC barrels entering the market helped propel this year's rally and consumer nations led by the International Energy Agency for months urged OPEC to pump more oil. At a meeting in September, OPEC agreed to increase oil output by 500,000 barrels per day from Nov. 1. Few in the group believe there is much they can do to tame a market they say defies logic.

Supply of crude from Nigeria, the world's eighth-largest oil exporter, has been cut since February 2006 because of militant attacks on the country's oil industry. Oil companies have detailed about 547,000 bpd of shut Nigerian production due to militant attacks and sabotage.

Oil consumers are concerned about supply disruption from Iran, the world's fourth-biggest exporter, which is locked in a dispute with the West over its nuclear programme. Western governments suspect Iran is using its civilian nuclear programme as a cover to develop nuclear weapons. Iran denies this, saying it wants nuclear power to make electricity. On Oct. 25, Washington designated Iran's Revolutionary Guard Corps a proliferater of weapons of mass destruction and its elite Qods force a supporter of terrorism.

Iraq is struggling to get its oil industry back on its feet after decades of wars, sanctions and underinvestment. Exports of Kirkuk crude from the country's north are sporadic as sabotage and technical problems have mostly idled the pipeline since the U.S.-led invasion of Iraq in March 2003,preventing exports returning to the pre-invasion rate.

Refiners in the United States, the world's top gas guzzler,struggled with unexpected outages which drained inventories ahead of the summer, when motor fuel demand peaks.