Crude oil: Hitting a Ton

Crude oil hitting the $100-abarrel mark now seems to be a matter of when rather than if. The run-up from $75 to $95 has been quite fast, accelerated by the weakening dollar, falling crude oil inventories and growing energy demand. From the beginning of ’03 till mid-’04, prices hovered between $25-$40. For the next two years, prices soared from $40 to touch nearly $80 per barrel.

In the second half of ’06, prices did drop till $50 but only to rally again in ’07. The Iraq war, growth of Asian economies and their energy consumptions, disruption caused by hurricanes in ’05 and US refinery problems involving conversion from MTBE as an additive to ethanol have been key factors contributing to the rise in oil prices over the last five years.

The recent spurt in oil prices is, however, not supported by a corresponding rise in demand or disruption in supply of crude. There has been no dramatic increase in crude oil consumption in last two years as shown by the table. In fact, since ’03, oil supply has closely tracked the demand growth. Demand for other sources of energy is growing much faster and share of oil in total energy consumption is declining steadily.

Since ’05, total demand for energy is growing at a compounded annual rate of 3%. Not surprisingly, many observers feel that high prices of oil have been partly due to speculation rather than any fundamental change in demand-supply situation.

The speculation in oil contracts has been aided by unprecedented liquidity flows into the global financial market, which has lead to asset inflation around the globe. An expectation of rising prices has converted crude oil into an asset class just like gold. Historically, investment in crude oil gives an excellent hedge against the weak US dollar. While the 5-year correlation between crude oil prices and the euro-dollar rate stands at 68%, the fast declining dollar has caused the correlation to accelerate to 94.5% since the beginning of ’07.

The second consecutive interest rate cut by the US Fed in less than two months along with an indication that it is not going to be the last one is favouring a bullish view for crude oil prices. So, do we see crude oil prices going higher from the $100 mark? According to data reported by Bloomberg, oil traders have raised their bets on crude oil at $125.