This morning’s trend of falling crude prices for January delivery and increases in crude prices for February delivery combined with rising heating oil prices on January and February contracts continued through the market’s close at 2:30 pm. January crude contracts lost 8% to close at $33.17 a barrel while February contracts rose by about 2% to $42.36 a barrel. Heating oil for January and February delivery rose at similar rates, with the January contracts closing up by about 1.5%.

As the NYMEX crude oil storage site at Cushing, Oklahoma rapidly approached capacity, oversupply of the market became more apparent. However, assurances by Saudi Arabia, the world’s largest oil producer, that it would reach decreased production targets next month helped raise bets on higher prices in February of next year. Expectations of another OPEC cut in January also helped boost February contract prices, as described on Blomberg.com:

“The scale of the cuts is quite significant,” said Rachel Ziemba an analyst at RGE Monitor, an economic research company in New York. “With oil at $35, members can’t balance their budgets. OPEC will find it hard to do more than they’ve already promised.”

HEAT USA price experts noted the price gains on NYMEX and predicted a corresponding increase in Monday’s retail prices.

HEAT USA Price Report
Evening Projection (for Monday’s average retail price per gallon): UP $0.03 to $0.04

Oil prices continued their epic fall today, touching a four-year low of $38.71 a barrel.  And a combination of statistics and trends appear to point to the low-price pattern continuing well into 2009.  A Wall Street Journal article detailed the evidence of still-falling demand in the world’s biggest oil-consuming nation: U.S. crude stockpiles have increased 11 of the last 12 weeks, and the Cushing, Oklahoma delivery point for NYMEX crude is just 500,000 barrels shy of record-high storage numbers.  The article also quoted analysis firm Tudor, Pickering, Holt, and Company’s estimate of $57.50 per barrel average price in 2009.

A second WSJ article examines the challenges that OPEC faces in its quest to cut production sufficiently to meet falling demand.  The main challenge, the article suggests, is the impossible task of predicting when worldwide demand will hit its floor: “Intuitively, low prices today should curb investment, meaning dearer oil tomorrow.  But against that, no one knows where falling demand will bottom out.”  A look at crude oil futures also indicates a tough task for OPEC.  Although advance contracts show a fairly steep price increase, they also reinforce the fact that the oil market is heavily oversupplied, as the article’s author explains in this video:

In fact, oil producers have more oil than they know what to do with, leading them to rent floating storage facilities as their land-borne storage spaces fill up.  Furthermore, when inflation is factored into distant futures prices, the increases are much less heartening for oil producers.  The furthest out contract, for December 2017 delivery, is currently at about $77 per barrel.  At a 1% rate of inflation, that $77 barrel would be worth 71 of today’s dollars, but at a 3% inflation rate, would only be worth $59 in today’s money.  The wide range of possible values for 2017 oil makes it even more difficult for producers to set targets and make decisions about expanding production in order to maximize profit.

As the market’s brush-off of the recent production cut shows, OPEC’s recent attempts to halt falling prices have had little or no effect, and available data supports the estimation that it may be a long while before the cartel is able to exert influence they way they would like, which of course means lower prices for longer periods.

A HEAT USA member recently contacted us with a great question: “I have always wondered why the price of heating [oil] is more than regular gasoline, when there are no taxes on it.” Actually, it is more of a statement, but still an interesting subject to wonder about.

It is logical to think that, since they are both refined from crude oil, that heating and gasoline should have similar prices per gallon. Add the state and federal taxes on gasoline, and you can expect gasoline to consistently cost more than heating oil, which is not taxed. Although this is sometimes the case, it is certainly not always the case. A quick look at the Energy Information Administration’s short-term energy outlook shows that on average, gasoline prices were in fact slightly higher than heating oil prices in 2006 and 2007. However, 2008 price averages and 2009 projected averages both show heating oil as slightly more expensive than gasoline.

So what accounts for these shifting price differences? First, we should note that gasoline and heating oil prices vary quite a bit in different areas of the country. A resident of New England might be paying $2.70 per gallon for gasoline and $2.95 per gallon for heating oil while a resident of Southern California might pay $3.05 per gallon of gasoline and $2.80 per gallon of heating oil. The point is, the most influential factor that determines how much you pay for gas and heating oil is where you live.

As for prices in the Northeast region right now, it seems that heating oil is more expensive than gasoline in most areas. There are two basic explanations for the current situation:

Supply and demand. Over the last few months, government statistics have repeatedly shown a steep drop-off in American demand for gasoline. Because of the tough economic times, Americans are driving less and therefore using less gasoline. Because demand for gasoline is historically low, oil companies are forced to lower retail prices to make sure they are still attracting customers. On the flip side, temperatures are dropping throughout the Northeast and winter is coming soon, so people are using more heating oil than they did three or six months ago. Higher demand for heating oil means that oil companies (both wholesalers and retailers) can raise their prices and still keep customers. In the summer of 2009, when Americans will be driving more and heating less, prices will most likely shift in the opposite direction.

Vertical consolidation. In the case of gasoline, most oil companies have what I call “pump-to-pump” control of the product. A huge multinational corporation like Shell owns the oil pump that extracts crude from the ground in Nigeria or the Middle East, owns the refinery that makes gasoline from the crude, and owns the pump that you use to put unleaded gas in your car. One company controlling the product through the entire production and retail process means the retail price is insulated from outside influences mainly profits taken by middlemen. Shell may be currently selling gasoline at a break-even price or even take some losses in order to keep sales up. When gasoline demand increases again (which it almost certainly will–the only question is when), Shell can then raise prices and recover most or all of the losses they incurred during the current low-demand period.

The extraction, buying and selling, and market trading of crude oil and its products like gasoline and heating oil are all incredibly complex processes. Although the simple explanations offered above to provide some insight as to how and why prices change, they cannot completely explain, much less predict, oil price trends.

The International Energy Agency (IEA) released a report yesterday that predicted that crude oil prices would soon return to triple-digit levels. Although the IEA did not specify how quickly the price increases would occur, it predicted that the price for a barrel of crude would average $100 from 2008 to 2015, and $200 from 2008 to 2030 (source: The Wall Street Journal).

Although historically-low demand for oil associated with the global economic slowdown has driven prices down in recent months, the IEA predicted that when demand eventually returned, supply would be extremely slow to catch up. According to the report, an average of $350 billion a year in oil investment would be required to keep pace with demand through 2030. That would be a lofty goal, especially considering the dampening effect low prices are currently having on oil investments around the world. One example appeared yesterday in The Economist: to exploit the presumably massive oil reserves in the tar sands of Canada, the price of oil would have to be at least $90 a barrel to make the difficult extraction of the oil financially worth while to oil companies. Plans to begin excavating the oil sands have been put on hold until prices rebound. Furthermore, the extensive investment needed to boost worldwide oil production is made more difficult by the lack of available credit as part of the economic downturn. The combined effects of low oil prices and tight credit make the increasing of oil production by the necessary level (estimated by the IEA) of 64 million barrels a day in order to meet 2030 demand levels extremely difficult.

The only solution, as outlined by the report and quoted in the New York Times, is making major changes to worldwide consumption patterns: “‘Current global trends in energy supply and consumption are patently unsustainable — environmentally, economically, and socially,’ the energy agency said. ‘But that can — and must — be altered.’”

The OPEC Flag and world map showing member nations.  Images: Wikipedia.com

Commodities markets are abuzz over OPEC’s planned meeting this Friday, at which the group is expected to reduce oil production substantially.  The news of the planned production cut caused the price of oil to increase almost immediately last Friday.  How can one organization be so powerful that one simple announcement can cause a sudden and profound change in the price of oil worldwide?  Who is OPEC and how did they rise to such an influential position?

The Organization of the Petroleum Exporting Countries currently has 13 members: Algeria, Angola, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela.  OPEC was founded in 1960 by Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela with this objective:

“…to co-ordinate and unify petroleum policies among Member Countries, in order to secure fair and stable prices for petroleum producers; an efficient, economic and regular supply of petroleum to consuming nations; and a fair return on capital to those investing in the industry.” (source: opec.org)

The motivating factor that led to its creation was the imposition of the Mandatory Oil Import Quota Program (MOIP) in 1959.  According to Benjamin Zycher in the Concise Encyclopedia of Economics, the MOIP, implemented by President Eisenhower, gave preferential treatment to crude and other petroleum products from nations outside the Persian Gulf (specifically Mexico and Canada).  After the MOIP depressed oil prices significantly, the founding nations of OPEC came together to raise oil prices.  Early attempts by OPEC to counter the MOIP and raise worldwide prices for oil were unsuccessful.  The organization continued to gain member nations through the 1960s and early 1970s, and finally showed its economic clout in 1974.

Following the Arab-Israeli Yom Kippur War of 1973, Arab members of OPEC implemented an embargo against the United States, Denmark, and the Netherlands as punishment for supporting Israel in the conflict.  Refusal to sell oil directly to the embargoed nations combined with large-scale, coordinated production cuts resulted in a spike in the price of crude that marked the beginning of a tenfold price increase from 1973 to 1980.

The 1980s brought plummeting oil prices and disunity in OPEC.  World demand decreased due to, among other factors, increased domestic oil production and utilization of other energy sources (coal, nuclear) in the US.  During the ’80s, OPEC export revenue decreased dramatically.

Despite OPEC’s efforts, crude oil prices declined from 1980 to the early 2000s.  Since then, the September 11th, 2001 attacks, two wars in Iraq (and the continuing occupation) have provided exceptions to the downward price trend by causing major supply interruptions in OPEC nations.  During this time, cohesion within OPEC has been spotty at best.  Member nations have repeatedly pushed for lower production quotas that would result in higher prices and higher profits.  In these cases, Saudi Arabia, the largest OPEC producer, has established itself as the “swing member” of the organization–it has declared itself committed to long-term price stabilization, and will adjust its production levels to offset production decisions by the organization that it views to be too drastic.

Today, it appears that OPEC has re-established itself as a major force on the price of oil and therefore a major player in the global economy.  With demand for crude falling in the US and in developing nations, OPEC is poised to make a big production cut in an attempt to raise and stabilize prices.  Oil analysts and economists disagree on whether or not the plan will actually be effective at buoying international oil prices, with many taking the position that the economic downturn will continue to depress demand faster than OPEC can cut production.  In the short term, however, last Friday’s rally on the oil market in response to OPEC’s announcement of its coming meeting showed us that OPEC’s voice is still heard by traders.  However much OPEC does decide to cut production at tomorrow’s meeting, Monday’s price of crude should give us a good idea of how the market will react.