Fear and Loathing in the Oil Markets

Supply is fine (really), and demand is too. So why do prices just keep rising?

By Rana Foroohar Monday, Mar. 14, 2011
    • Illustration by Harry Campbell for TIME

    Oil is primal. Like food, it's necessary to our survival, and when we fear that our ability to heat our homes and fuel our cars might somehow be in danger, we panic. That's a key reason petroleum prices have jumped so wildly off the back of the turmoil in the Middle East in recent weeks. The current price of oil — $116 per barrel as of March 1 — is at least $20 per barrel higher than what experts say it should be, based on the simple logic of supply and demand. The same was roughly true during any number of past oil spikes, from the Iranian revolution to the Gulf War in 1991; in those two cases, prices were 30% higher than they should have been, based on the facts on the ground. As it was then, it is often fear rather than reality that drives oil prices.

    To understand how this is playing out today, forget about bombed-out Libyan refineries and emergency evacuations of oil workers and consider the facts: Libyan oil represents less than 2% of the world's daily supply. As soon as the troubles began, the Saudis (who control 25% of the world's proven reserves) said they'd immediately pump enough additional oil to make up for the Libyan disruptions. As Saudi Oil Minister Ali al-Naimi put it, "OPEC is ready to meet any shortage in supply when it happens. There is fear and concern, but there is no shortage."

    His words underscore the fact that the Saudis will do anything necessary to ensure the stability of their regime. They have their own fears — namely, of revolution. This is clear from the fact that in addition to pumping more oil, they are pumping $36 billion worth of stimulus into their domestic economy in the hopes that unemployed young people in the kingdom won't take to the streets as their peers elsewhere in the Middle East have done. Still, the idea that there is no real shortage of oil in the world is not just Saudi hubris. Until Libya, the world had plenty of spare oil sitting around — about 6 million barrels per day. "That's huge by historical standards," notes Robin West, the head of Washington-based consultancy PFC Energy. "In the old days, that would have implied much lower oil prices."

    But these are the new days — days in which rising energy demand in China and other fast-growing emerging markets is pushing prices up, as are investors who increasingly see oil not just as fuel but also as a financial instrument. A lot of pension funds are now heavily invested in oil, and so are any number of speculators. Ben Bernanke may deny it, but plenty of Wall Street investors I speak with believe that the U.S. government's decision to keep the easy-money gravy train going has also led to higher oil prices: all that hedge-fund money needs somewhere to go.

    That's another reason the fear factor in oil may continue to rise. More speculation in energy markets means more uncertainty. And there's going to be plenty of that in the energy business. Fear has increased the volatility of oil prices, and that has created a snowball effect, in which the industry has grown wary of investing in new facilities and expensive exploration. Such investments would ultimately lower prices by bringing more new energy supplies online. But oil is a costly business, and industry executives don't want to pour billions into new exploration if they don't trust prices will stay high for very long.

    Consider the last major oil spike, back in 2008, when the per-barrel price went to a nosebleed $148. There were many reasons for the uptick, including strong growth in the global economy over many years and a speculator-driven bubble toward the end of the boom. But another significant reason was that in the two decades leading up to the spike, the average price of oil was just $20 a barrel. With prices that low, nobody wanted to invest — which meant that once demand suddenly began to rise, everything from oil engineers to offshore rigs was in short supply. That pushed prices up fast.

    All this points to a truism about oil: it's an uncertain business, even for experts, and uncertainty leads to fear. But for all the things we don't know about oil, one thing is certain: today, Western oil companies have access to only 25% of the world's known reserves. Thanks to another megatrend in the business — rising oil nationalism — the rest lies in the hands of state-run companies in countries throughout the Middle East, Africa and Asia, many of which are autocracies. That, more than any temporary shutdown in Libya, is the real reason to be fearful.