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What Makes Oil Prices So High?

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Oil Prices Rise As BP Shuts Pipeline
David McNew/Getty Images News/Getty Images

In late August, prices for October delivery of Brent crude oil rose to $115.59 a barrel, the highest in six months. Prices for West Texas (WTI) crude rose to $109.98 a barrel, an 2-year high. Traders were bid up prices after the U.S. announced it would use air strikes to punish Syria, after President Assad used chemical weapons to kill hundreds of civilians.

Syria is not a major oil supplier, but traders were concerned about the possible implications of the strike. These include disruption of oil from Iran, Syria's major ally; turmoil in Iraq; and further disruptions in Egypt. (Source: WSJ, U.S. Oil Futures Settle at Two-Year High Amid Syria Concerns, August 28, 2013)

2013 - A Year of Volatile Oil Prices:

On July 18, 2013, oil prices hit $109.71 a barrel for Brent crude oil. The catalyst was the removal from office of Egypt's democratically elected President, Mohammed Morsi. Commodities traders worried, without reason, that the Suez Canal could be closed if unrest spread.

A contributing reason is that investors are more confident that demand for oil will increase with the growing global economy. For more, see Will 15-Month High in Oil Prices Drive Up Gas Prices?, July 8, 2013

In January 2013, oil prices started rising earlier than ever. Iran kicked off the year by playing war games near the Straits of Hormuz. This was perceived as a potential threat to this strategic shipping lane. By February 8, oil reached $118.90/barrel. This sent gas prices to $3.85 by February 25. Since then, oil and gas prices have leveled off. Prices are expected to average $105 barrel for Brent crude oil in 2013.

This is lower than 2012's average of $112 per barrel. The EIA bravely forecasts the average price of oil will fall even more in 2014 to $99 per barrel. Why? U.S. pipeline capacity will be expanded, allowing greater supply. Demand will be only mildly supported by moderate economic growth in the U.S. The EIA forecasts growth to be at the low end of the healthy 2-3% growth rate. (Source: EIA, Short-Term Forecast)

Reasons for High Oil Prices in 2012:

Oil prices started rising much sooner in 2012 than they did in 2011. The price for WTI crude oil broke above $100 a barrel on February 13, 2012, two weeks earlier than in 2011. Rising oil prices drove gas prices above $3.50 a gallon that same week. Gas prices had already breached $3.50 a gallon on the East and West coasts in January.

By March, Brent Crude Oil (which is more expensive than WTI) peaked at $125 a barrel. It settled down to $95 a barrel in June, but rose $113.36 by August. Normally, oil prices drop in the fall and winter. However, commodities futures traders were bidding up oil prices to offset what the Fed's expansive monetary policy. They were betting the dollar would drop, which drives up oil prices. They were wrong about the dollar, but oil prices rose despite lower demand. (Source: Forbes, The Price of Oil Is the New Economic Spoiler, September 12, 2012)

People were concerned because gas and oil prices rose earlier than in the past. However, less and less of oil prices are due to supply and demand. More and more of it is based on the expectations of commodities markets.

Why Oil Prices Rose in 2011:

Crude oil prices reached a recent high of $113.93 on April 29, 2011. Prices had been increasing steadily since February 2009, when prices dropped to $39 a barrel. Prices hovered at a comfortable $70-$80 a barrel until late 2010. High oil prices translate to high gas prices. Petroleum is also an ingredient in fertilizer. This, combined with higher transportation costs, increases food prices. The forces driving high oil prices are similar to what happened when oil hit an all-time high in 2008.

The All-Time High Was $143.68 a Barrel in 2008:

Oil prices hit an all-time high of $143.68 a barrel in July 2008, after skyrocketing 25% in three months.This drove gas prices to $4.17 a gallon. Most news sources blamed this on surging demand from China and India, combined with decreasing supply from Nigeria and Iraq oil fields.  For more, see Gas Prices in 2008. (Source: BBC, Oil Price May Hit $200 a Barrel, May 7, 2008)

However, even then this wasn't logical, since the economy was already in a recession. Global demand in 2008 was actually down and global supply was up. Prices rose, nevertheless. Oil consumption decreased from 86.66 million barrels per day (bpd) in the fourth quarter 2007 to 85.73 million bpd in the first quarter of 2008. At the same time, supply increased from 85.49 to 86.17 million bpd. According to the laws of supply and demand, prices should have decreased. Instead, they increased almost 25% in that time - from $87.79 to $110.21 a barrel. (Source: EIA. See Google Spreadsheet)

Commodities Trading Drove Up Oil Prices:

Why? Although the EIA pinned part of the blame on volatility in Venezuela and Nigeria, it warned of an influx of investment money into commodities markets. Investors were stampeding out of the falling real estate and stock markets. Instead, they diverted their funds to oil futures. This sudden surge drove up oil prices, creating a speculative bubble. (Source: EIA Short-Term Energy Outlook)

This bubble soon spread to other commodities. Investor funds swamped wheat, gold and other related futures markets. This speculation drove up food prices dramatically around the world. The result? Food riots in less-developed countries by people facing starvation. (Source: BBC News,Commodity Boom Continues to Roll, January 16, 2008; CNN, Riots, Instability Spread as Food Prices Skyrocket, February 18, 2008)

What Drives Oil Prices Today?

This explains why oil prices are lower today than they were in 2008, despite a healthier global economy and greater worldwide demand for oil. Today, there are many more outlets for investment funds. In 2008, the global markets were so risky and uncertain, investors turned from stocks, bonds and even housing to the U.S. dollar, gold and oil. In 2012, despite uncertainty around the eurozone crisis, investors had many more options. The stock market rose, the bond market was less risky, and even housing improved. Although the global market is still in slow growth mode in 2013, it is stabilizing, and that means oil prices shouldn't break the peak hit in 2008.

High oil prices are also driven by a decline in the dollar. Most oil contracts around the world are traded in dollars. As a result, oil-exporting countries usually peg their currency to the dollar. When the dollar declines, so do their oil revenues, but their costs go up. Therefore, OPEC must raise the price of oil to maintain its profit margins and keep costs of imported goods constant. (Source: USA Today,Oil Briefly Spurts Near $104 per Barrel, March 3, 2008)

However, OPEC doesn't want oil prices too high, or alternative fuel sources start to look good. OPEC has said its target price for oil is between $70-$80 a barrel. In 2008, Saudi Arabia announced it would increase supply. This was one reason prices started to drop. (See High Oil Prices Caused by Wall Street, Not OPEC) (Article updated August 28, 2013)

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