What’s Driving the Price of Oil?

Gas prices are not keeping Americans at home this Memorial Day weekend. AAA projects that 34.8 million Americans will travel 50 miles or more this holiday weekend.

Here at the Portfolioist, we thought the start of Memorial Day weekend would be a good time to re-examine what drives the price of oil. This article was first published by Geoff Considine on May 4th.

From all of us at the Portfolioist, have a happy and safe Memorial Day.

There’s lot’s of talk right now about the price of oil and, particularly, gasoline, and it looks as though the price of a gallon of gas will be a significant political topic for the election this year.  President Obama recently proposed new rules for limiting the influence of speculators on the oil market.  Politifact, a media group that fact checks the truthfulness of political statements recently ran a piece on public statements about oil prices.  Their conclusion is that much of what is being claimed with regard to the causes of high oil and gas prices is, at best, based on half truths.

Speculation vs. Supply and Demand

By contrast to much of the focus on speculators as being the cause of high prices, The Economist makes the argument that the current price of oil is due to a far more benign cause: the balance of supply and demand.  Lower productivity of oil wells combined with soaring demand for energy in the developing world have resulted in higher demand relative to production with the inevitable result that prices are higher.   The demand for oil in the Asia/Pacific region has climbed fast and steadily over the last decade, and the demand has proven remarkably insensitive to variability in price.  These data aside, however, Exxon’s CEO recently stated in testimony before the U.S. Senate that oil prices would be around $60-$70 per barrel on the basis of supply and demand.

Finance professor Craig Pirrong, director of the Global Energy Management Institute at the University of Houston, has focused on the role of speculators in commodity markets in his research.  He concludes that speculators play a relatively small role in determining the price of oil.  Pirrong cites the current very low price of natural gas, for example, as demonstrating that speculation is not somehow uniformly raising commodity prices.

Making Sense of the Issue

Despite the fact that I worked on the trading floor of an energy commodity trading firm and also for a consulting firm serving these markets, much of the current debate around this topic baffles me.  Nobody likes to pay $70 or more to fill up their car’s tank, but it is entirely possible that we simply need to reconcile ourselves to a new global reality.

Despite having a much better-than-average grasp of the mechanics of energy markets, I do not feel confident that I understand the role of speculators in determining the price of a barrel of oil or a gallon of gas.  Given the rapid growth in demand in the developing world, however, I am of the opinion that oil prices will be higher in the future than we, in the United States, have become accustomed.  That said, I certainly don’t have the expertise to debate with Exxon’s CEO over his assertion that the ‘fair price’ of oil is far below where it is today.

Workable Solutions

Since I am inclined towards pragmatism, I tend to look for simple solutions to complex problems.  We need to drive less, buy cars which get better mileage, insulate our homes better, and look for other ways to reduce energy consumption and, particularly, our national dependence on foreign oil.  This is the no-regrets solution to the problem of higher gas prices.

From an investment standpoint, the issue can seem overwhelming.  The simplest solution is that investors need exposure to commodities and/or companies that produce oil and other commodities as part of their portfolios.  This is not so much a bet on oil prices specifically as a way to ensure that long-term portfolio purchasing power keeps up with inflation.

Related Links:

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

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