Oil: How High from Here?

[Dan]

Prices could reach new record highs as traders bid up oil in reaction to a weak U.S. dollar brought on by low interest rates
The news from the trading pits is, well, no news at all: Oil prices are again breaking records. On Apr. 21, the price of a barrel of the benchmark West Texas Intermediate crude for May delivery hit $117.76 on the New York Mercantile Exchange—an all-time high—before settling at $117.46. On Apr. 22, crude hit yet another all-time high of $118.05 in electronic trading before retreating slightly. Oil prices are up 23% so far this year, and 16% in April alone.

Those prices in the futures market are hitting consumers in the here and now, rippling through everything from gasoline to food to home heating fuel. The average price of a gallon of regular unleaded gasoline hit a high of $3.50 on Apr. 21. Diesel prices also set a record, at $4.20 a gallon, according to AAA and the Oil Price Information Service.

Not surprisingly, consumers are looking for a culprit. In a comment posted to a BusinessWeek.com opinion piece arguing that there is no actual shortage of gasoline (BusinessWeek.com, 4/1/08), "Ward" wrote on Apr. 17: "Impeach the oil cos. Then impeach their main apologist, GWB [George W. Bush]." Indeed, some oil-company stocks rose along with crude on Apr. 21, with Hess (HES) closing up 7% at 112.56; ExxonMobil (XOM) up 0.3% to 94.26; and Marathon Oil (MRO) up 0.9% to 49.21.

But analysts say a complex mix of factors—from low interest rates to the sagging dollar to the faltering economy—is behind the oil price hike. And they don't expect a letup any time soon.

"This [price spike] isn't an issue of supply and demand," says Joel Fingerman, principal of Chicago-based Oil Analytics, an energy consulting firm. "This is about money flow. It could stop here or at $150."

An Effect of the Declining Dollar
In other words, traders are bidding up the price of oil. It's the downside, in one sense, of the scramble by the Federal Reserve Board to rescue the financial markets in the wake of the subprime mortgage meltdown. Since October, the Fed has been consistently cutting interest rates—most recently on Mar. 18, and it's expected to do so again on Apr. 28. Each time it does so, the value of the dollar falls against other currencies. Traders react by investing in other commodities as a hedge against the falling dollar, and dollar-denominated commodities (such as oil) become more expensive.

"As long as the Fed continues to cut rates, traders will keep selling the dollar, buying the euro, and buying commodities like oil," says Peter Beutel, president of the New Canaan (Conn.)-based energy risk management firm Cameron Hanover. It also doesn't help that investors are still skittish about putting more money into stocks. "Traders are relentlessly long [on oil] because there's nowhere else to go," says Phil Flynn, an analyst and vice-president at brokerage firm Alaron Futures & Options in Chicago. "They're heading to oil and other commodities for safety."

It's unclear how much lower the dollar can go. The euro has been gaining ground against the dollar since 2003, and has risen 24% against the dollar since January, 2007. The euro increased 0.4% to $1.59 on Apr. 21—within 1¢ of a record—as European Central Bank officials reiterated concern that inflation has accelerated.

The Mother of All Corrections?
Some analysts say oil's sharp climb will only lead to a sharp and painful correction. As inflation causes consumer spending to slow, and endangers industries from airlines to trucking—at a time when the economy is weak anyway—it's logical demand for oil-based products will fall.

It wouldn't be the first time: Crude prices more than doubled in four months during 1990, after Iraq invaded Kuwait, to more than $32 a barrel. But prices had plummeted by about a third the following January. And by 1998 oil was trading below $11 a barrel. "I don't think the path we're on is sustainable," says Flynn. "Even if this is a long-term bull market [in oil futures], we're getting close to what could be the mother of all corrections."

But some traders are betting that low interest rates, a feeble dollar, and robust demand from China and India will keep demand for energy stoked and prices high. Fadel Gheit, senior energy analyst for Oppenheimer (OPY), says unless the U.S. government steps in to rein in speculators' power in the market, prices will just keep going up. He says the U.S. has been "unable or unwilling" to regulate oil markets, which proves a convenient way to contain the growth of China and spur energy conservation in the U.S.

"We're tolerating high prices for a reason," says Gheit. "No one has the courage to give us the bitter medicine of high taxes, so speculators have control of this market. There is no conductor on this train."