Why Are Oil Prices So High? Because Crude Is as Good as Gold

Why Are Oil Prices So High?
Why Are Oil Prices So High?

The oil market, like other markets, is one in which prices are largely determined by what traders and investors call "market psychology."

That's because at any given time, there's usually enough evidence to justify either a bullish or a bearish argument, and it's often when one viewpoint or "psychology" becomes dominant that a price trend is established.

For about a year, the oil bulls, who argue that oil is not only an energy source but also an alternative investment, have prevailed over the oil bears, who argue that oil's price is too high given ample supplies and modest demand. During that period, the price of oil soared by about 120%, from its low point at $35.13 per barrel in December 2008, during the acute stage of the financial crisis, to about $77 today.

OPEC: The 800-Pound Gorilla

However, the market psychology argument doesn't mean that OPEC, which represents the producers of about 40% of the world's oil, hasn't played a role in pushing oil's price higher by rationing its share of the global supply. It has, having cut its stated production by more than 4.2 million barrels per day since late 2008, when demand fell as the world economy entered its first synchronized global recession since the end of World War II. And unlike past downturns -- when OPEC members frequently "cheated" and pumped more oil than their quotas to maintain revenue -- compliance this time has been relatively good. Roughly half of the 11 OPEC members operating under quotas have been complying with them, according to OPEC's measures, with the cartel pumping just 29.25 million barrels per day in April. (Iraq, though a member, is not currently bound by a quota.)

Clearly, OPEC's production cuts have taken a large amount of supply off the market, and that has raised the price of oil, but the group's cuts alone can't account for today's $70-plus prices -- high compared to oil's real, historical average, and very high given the long recession, which sapped demand in the United States.

Further, the market has a roughly 1 million bpd global supply cushion above OPEC's 85.38 million bpd estimate of global oil demand (which the group raised by 50,000 barrels per day Tuesday), and OPEC has 3 million to 5 million bpd of spare production capacity, both of which make a $70-plus oil price seem all the more curious. And that's where the market psychology of "oil as alternative investment" comes in to play.

Oil As Energy Source, Asset and Hedge

The oil bulls argue that oil isn't just fuel, but an alternative asset and a hedge against a further weakening in the dollar. They therefore believe that the power of their viewpoint will prevail over supply-and-demand factors when it comes to oil's price. For those who view oil as an investment, the past year has been profitable: Even if an investor caught oil's rally late, say, in July 2009 when oil traded around $60, she would still be up about 28% -- not a bad annual return on an investment. For the hedgers, oil, which is priced in dollars, usually rises when the dollar falls, and vice versa. In this, it behaves like that other favorite hedge commodity, gold. One could argue that the dollar may weaken further in the years ahead, particularly if the U.S. does not cut its large budget deficit.

Of course, other factors can influence the price of oil. Gasoline demand in the U.S. is one. Strong domestic demand usually leads to higher gasoline prices, and if the price of gasoline rises, it makes crude oil more valuable. Large, sustained changes the GDPs of emerging-market nations -- major sources of new oil demand -- also can move oil's price.

But oil over the past year has stayed stubbornly high despite the recession, demonstrating clearly how factors unconnected to supply and demand play a role in its price. So when you're trying to forecast oil's price direction, it certainly makes sense to know how the U.S. and global economies are faring, as well as how much oil OPEC has decided to produce. But it also make sense to know where the dollar is headed and how other assets, such as stocks, are likely to perform.