What keeps driving oil prices higher?

/ Source: msnbc.com

With oil prices racing toward $70 a barrel, Answer Desk readers want to know what it will take to send prices lower again. Wyatt in Florida wants to know just how much more oil is out there. And Mark in San Francisco can't see why oil speculators are allowed to bid up prices -- and ruin life for the rest of us.

I did some math on your estimates of oil consumption and reserve. You estimated 82 million barrels per day consumption with a 2 million per barrels per day increase which is close to 2.5 percent. If I take your figure for known reserves at 1 to 1.2 trillion barrels this comes out to exhaustion of known reserves in about 15 years. That would seem to me to be bordering on crisis! Have we discovered all the oil or do we have other (supplies) available?
-- Wyatt B., Wellington, Fla.

The only honest answer is that no one knows for sure. Optimists (mainly those in the oil industry) will tell you there’s plenty of oil out there for at least another few decades — if not longer. Pessimists, using some fairly sophisticated analysis of oil reserve data, believe that the relentless rise in oil prices is the direct result of the world’s demand for oil close to exceeding supply. Some believe we’ve already reached that point.

Who’s right? You have to start with the fact that the total amount of oil underground is really unknowable. Even with the technology available to today’s “Nintendo geologists” — who can “see” underground by displaying 3-D seismic data on room-sized screens — identifying oil deposits is not an exact science.

To cope with this uncertainty, petroleum geologists and oil executives have come up with several ways to describe what’s out there. “Known reserves” are oil that’s been found but not produced. This is then broken down into “probabilities.” So-called P90 (“proven”) reserves are those where geologists figure there’s a 90 percent probability that the oil field is as big as they say it is. They also calculate P50 and P10 estimates. So a specific oil field might have P90 reserves of 100 million barrels and P10 reserves of 1 billion barrels. It’s not like figuring out how much gas you can put in your tank.

Then there’s the question of how much is really “recoverable” — you may be able to see it, but it’s just not feasible (or economic) to get at it. Modern horizontal drilling allows oil producers to squeeze barrels of oil out of tight spots that were considered inaccessible 30 years ago. But you can’t really know just how much oil you’ll get until the last well dries up. (Actually, it usually “wets up” as underground water replaces the flow of oil.)

And the big number, called the “ultimate recoverable” reserve of oil requires an even bigger guess: How much oil is out there that hasn’t yet been found? (No surprise: estimates vary widely on this one.) The oil industry spends billions of dollars every year looking, but with a few exceptions there haven’t been any major new oil fields (on the order of say, the North Sea) found in the past several decades. It’s always possible some big new oil field is out there. But the global oil industry has already poked an awful lot of holes where the geologists told them to look. Meanwhile, existing oil fields aren’t getting any bigger.

Many pessimists argue that it doesn’t matter how much oil is underground: the critical question is: How fast you can pull it out of the ground every day. Once you find oil, it takes years to drill the wells and install the pipelines and build the processing stations needed to produce it. Excess production capacity — the difference between what you can pump and how much is consumed — has been steadily shrinking worldwide for decades. Today, it’s pretty much gone.

According to the U.S. Energy Information Administration, global oil production hit 84.5 million barrels per day in May (the latest numbers available) and demand in the first quarter averaged 84.4 million. That leaves a margin of about one-tenth of one percent. That’s why oil prices are rising.

So, in the short term, the question is whether oil producers can add capacity fast enough to keep up with relentless growth in demand. Saudi Arabia is one of the few producers that has promised to keep expanding production to try to keep up: It remains to be seen whether that’s possible. And it’s not easy to predict how fast demand will continue to grow.

But one thing is certain: the world has never been this close to seeing oil demand overtake production capacity. Unless production keeps up with demand, oil prices will continue moving higher.

What safeguards do Americans have against speculators in the oil futures market speculating the price of oil to infinity?  Why are hedge funds being allowed to invest trillions of dollars in the future's market and driving up the price of oil for all of us?
Mark -- San Francisco,  Calif.

As much as we'd all like to see it happen, you really can't put a cap on the price of oil. First of all, with a truly global market for crude, who would enforce a price cap? The U.N.? The U.S. military? All you'd have is lots of black market dealers skimming even more money off the price you eventually pay as a consumer.

Worse, when supplies of a commodity get tight, and you keep the price fixed, you tend to run out of that commodity pretty quickly. (Think of trying to buy batteries at the hardware store when a hurricane is approaching.) Would you prefer rationing? (Again, who would decide who gets how much?) Since raising prices is essentially the form of rationing we have, the real question is: What's a "fair" price for this increasingly precious commodity?

And the safeguard is the market itself: Futures markets can drive prices down just as powerfully as they drive them up. And whenever any market gets too hot — whether for oil or tech stocks or unbuilt condos in Florida — speculators who bet the wrong way get burned.

There are several ways to buy oil. You can buy from a dealer at the so-called “spot” price — sort of like the pump price for gasoline. Or you can lock in a fixed price with a supplier under a long-term contract.

Or you can buy a contract to buy oil — which is nothing more than a piece of paper with a lot of legalese and, most importantly, a fixed price and a delivery date. As of Friday, for example, you could have bought 1000 barrels of crude for $66.86 and have it delivered in next month. That’s why they call them “futures” contracts — you have to wait for your oil. Right now, you can buy oil for delivery in any month between September and December, 2006. You can also buy a December contract for any year out to 2010.

Some people who buy these contracts are oil dealers, who fully expect to have the oil delivered. Other big oil consumers (like, say, an airline or trucking company) will buy contracts to “hedge” oil price increases. are bought by these “commercial traders.”

The rest are bought by investors (read: Speculators) who want to make money buying and selling the contract at a profit. But they’ve got to unload that paper before the delivery date or a tanker truck will show up in their driveway asking where they want the oil dropped off.

The recent run-up in oil prices has almost certainly been due, in part, to speculators buying these contracts — betting that tight supplies of real oil will continue drive prices even higher.

But when these speculators get ahead of themselves — bidding up prices higher than the market is willing to pay for real oil — prices reverse course and can fall quickly, catching the lazy ones off guard and costing them big bucks. There have been several sharp pullbacks this year, and the folks on the wrong side of the market most definitely lost money. If you bought that oil futures contract we told you about on Friday, for example, you would have lost about $560 by Monday morning.

So why turn the oil markets into a gambling parlor in the first place? For one thing, the only way to set a “fair” price is to let everyone bid on the commodity who wants to buy it. The oil markets have so many traders bidding every minute, the price reacts quickly to changes in the market. Everyone can see what the last barrel sold for. So even if you don’t like to price you’re offered, you can be pretty sure it’s the best price you’re going to get.