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Oil market pullback may be short-lived

With global demand for oil pushing the limits of world production capacity, the recent  pullback in prices may be short-lived, and these large, sudden price swings may become much more common. By's John W. Schoen

As crude oil shortages caused by a string of September hurricanes have begun to ease over the last month, oil consumers have gotten a break. In just a few weeks, prices have fallen $9 from record highs above $55 a barrel.

But the latest supply numbers reported Wednesday include some ominous signs that prices could soon be headed higher again — especially for heating oil and diesel fuel. And with global demand for oil pushing the limits of world production capacity, these large, sudden price swings may become much more common, analysts say.

In its latest weekly report, the U.S. Department of Energy said that stockpiles of crude rose by 800,000 barrels, or less than one percent, to 292.3 million barrels, slightly above year ago levels. Light crude climbed 73 cents to $46.84 per barrel on the New York Mercantile Exchange. In London, Brent crude — which is cheaper because its higher sulfur content makes it less attractive to some refiners — fell 24 cents to $42.05.

But U.S. supply of distillate fuel, which includes heating oil and diesel fuel, fell by 1 million barrels to 114.6 million barrels, or 14 percent below year ago levels. Heating oil supplies are also tight in Europe and Japan, which are major consumers during the cold winter months.

“What we may be seeing now is a fool’s pullback,” said Bill O’Grady, an energy futures analysts at A.G. Edwards. “It’s November 17th. You’ve got 2 to 3 months of winter in front of you.  If you get a cold winter would new highs shock me? Not in the least.”

Diesel fuel prices have soared above $2.10 a gallon — up 60 cents from a year ago and surpassing gasoline prices in some areas. With supplies of distillates below their five year average, demand for diesel has surged, largely because of increased consumption by rail and trucking companies. Moderately strong U.S. economic growth is part of the reason, as is the 15 percent gain in imports — roughly $150 billion worth of goods each month — that doesn’t show up in U.S. Gross Domestic Product figures.

“Trains are packed up to the gills right now,” said Phil Flynn, in Chicago. “The trucking industry is at the strongest level it has been in years.”

While crude futures are about 40 percent higher than a year ago, they would have to reach $90 per barrel to meet the inflation-adjusted peak set in 1980.

Oil traders have been keeping a close watch on the weekly inventory numbers because the usual fallback — big production increases by major OPEC producers — no longer seems likely. Global production is now running just one percent above the world's daily consumption of 82.4 million barrels, a razor thin cushion that leaves little room for either a production outage or a further increase in demand.

Oil industry experts are divided on whether new oil supplies can be found quickly enough to keep up with growing demand. One leading proponent of the theory that oil production is peaking, Princeton University geologist Kenneth Deffeyes, predicts that global output will reach its limit by late next year and then gradually begin declining.

Meanwhile, global demand shows no signs of slowing, particularly in major developing nations like China and India. In its latest report, the U.S. Department of Energy once again bumped up its estimates of oil demand this year to show a 3.5 percent gain over last year. And demand is expected to grow another 2.4 percent next year.

Oil supplies may get even tighter if China and India follow through with plans to develop their own strategic petroleum reserves, similar to stockpiles currently held by the U.S. and European nations. The U.S. Strategic Petroleum Reserve, currently set to top out at about 725 million barrels, would be increased to 1 billion barrels if the Bush administration's pending energy bill is approved by Congress. Diverting oil into those strategic stockpiles would take hundreds of millions of barrels of oil off the market and further tighten supplies.

At the same time, oil supplies from several key producers remain threatened.  In Russia, embattled oil giant YUKOS, which produces 2 million barrels a day,  recently reported that has paid just under a quarter of its total $18.4 billion back tax bill and that the government has been unresponsive to its debt-settlement proposals. In Nigeria, the world's seventh-largest exporter, rebel forces fighting to take over the oil-rich Niger Delta have stopped handing over weapons to a government-appointed disarmament commission claiming the process was not transparent.

And with so little cushion in the market, sudden price swings like the one seen over the past few months could become the norm. Any cutoff in supplies in the near future could quickly send prices spiking above $50 — and beyond. As supplies are restored or demand eases, those surges could be followed by sudden pullbacks — all of which could make it extremely difficult for businesses and households to manage their energy spending.

It also makes forecasting prices especially difficult, according to Deffeyes, because the usual laws of supply and demand are breaking down in the case of oil. Economists insist that rising prices eventually reduce demand. But that’s not always true for a commodity that consumers have a hard time doing without, he said.

“The system is now very unresponsive to price,” he said, “because there are some commuters who can’t move their house. In the short run, they’ll pay for the gasoline.”