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The debate behind $80 oil

Industry executives say there's no reason crude prices should be anywhere near current levels. Others say the fundamentals are there, and Big Oil is playing politics.

By Steve Hargreaves, CNNMoney.com staff writer

NEW YORK (CNNMoney.com) -- To listen to Big Oil executives, there's no reason why a barrel of crude costs $80. But others say strong demand and limited supply justifies at least that much, and that the industry is clearly looking out for itself by saying oil is overvalued.

"No one has to wait at the gas pumps of the world. There is no physical problem," Jeroen van der Veer, head of Royal Dutch Shell, recently told reporters in Calgary. "[There's] a lot of psychology in the price."

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Oil executives say there's no reason why crude should be at $80 a barrel. But experts say the fundementals support at least that much, and that the industry has political reasons for trying to talk down the price.

Van der Veer's comments echoed those of Exxon Chief Executive Rex Tillerson, who said earlier this month that he "cannot explain why we have $70 oil today. We are not having trouble finding oil. There is something else going on that I don't get."

Exxon declined to elaborate on Tillerson's remarks, and a spokesperson for Shell was unavailable for comment.

But for some, the motivations behind the executives claims are clear.

"They have political motivations for trying to talk down the price of oil," said Ken Carol, an oil company analyst at Johnson Rice & Co, a research and investment banking firm.

"If you were the favorite whipping boy of policy-makers, wouldn't you say the same thing," said Mike Fitzpatrick, an analyst and trader on the energy desk at Man Financial in New York.

Previous spells of record-setting prices have prompted calls for a special tax on oil company profits, closing some tax loopholes, and even breaking up the big oil firms, such as Exxon Mobil (Charts, Fortune 500), ConocoPhillips (Charts, Fortune 500) and Chevron (Charts, Fortune 500).

This time around, politicians have been relatively quiet. Oil passed the $80 a barrel mark last week as debate concluded on broad-ranging energy bills that include eliminating some oil industry tax breaks. House and Senate negotiators are currently trying to reconcile the two bills.

In addition to hoping to duck further government action, the industry may also be trying to deflect criticism for what some say is a lack in investment in oil production and refining capabilities.

While oil companies don't control the price of oil directly, they, along with OPEC, are largely responsible for the supply. They are also responsible for building refineries that turn crude oil into usable products, such as gasoline and heating oil.

One analyst, who declined to be named, said the industry may be trying to shift attention away from the fact that no new refineries have been built in this country since 1976. The analyst said the oil companies would rather invest in drilling and production efforts rather than refining, where up until recently profit margins had been much lower.

A spokesman at the American Petroleum Council notes that capacity at existing refineries has expanded substantially, and says community opposition and environmental laws make building a new refinery difficult.

Timing has not helped the supply situation either. Throughout most of the 1990s crude traded between $10 and $20 a barrel. That left little money for new exploration and production projects.

Then the worldwide economy boomed in the early 2000s - and continues growing today.

"The economy is not giving the oil companies the time they need to bring new resources to market," said Peter Beutel, an oil analyst at the consultancy Cameron Hanover.

Even with today's high prices, many oil companies return more cash to shareholders through stock repurchases and dividends than they invest in exploration and production projects.

Although top oil executives feel $80 is too high, there's an ongoing debate among experts as to whether that price is justified.

Since early 2000 the strong and growing oil demand in the U.S. and abroad with fairly static supplies is the main reason behind oil's surge, according to most analysts. Oil has gone from $20 in 2002 to over $80 today.

That price jump has also attracted lots of investors, which could be the "something else going on" that Tillerson believes is driving up prices.

"There's clearly some financial players pushing up the price of crude," said Carol of Johnson Rice & Co. "Given the current supply-demand scenario, $80 is not justified."

But opinions are split as to just how much speculative investors are driving crude prices.

Beutel notes that only 18 percent of the "long" contracts on the New York Mercantile Exchange - meaning bets where the investor thinks the price of oil is going to go up - are held by investment funds. Seventy five percent are held by people who actually use the oil.

Moreover, he said only 9 percent of the total contracts on Nymex are held by investment funds.

"I just don't buy the 'speculators are doing it' argument," said Beutel.

Fitzpatrick, a speculator himself, said the investment premium on each barrel of oil is only about $4 or $5. The rest he said can be attributed to the fundamentals: "China is not going away, India is not going away," he said. "They are going to drink up this oil."

So is there really a supply crunch or is it simply a case that speculators are driving up prices?

While supply appears to be growing, much of it comes from OPEC. That fact builds a risk premium into the price of crude. Whether it should add up to $80 a barrel is clearly an ongoing debate.

The Energy Information Administration makes projections about how much extra oil the world has. Known as spare production capacity, it's the difference between what the world currently consumes and what it could produce.

That number has been quite small over the last couple of years, which only exaggerates the effects of geopolitical events - as there's less extra oil to cover demand if supplies get disrupted.

The world currently consumes about 86 million barrels of oil per day, and EIA estimates current spare production capacity is about 2.17 million barrels a day. Yet that's projected to grow to 2.25 by the end of the year, and average 2.70 million barrels a day in 2008 - still tight, but not exactly supportive of the 'rising demand static supply' scenario.

But maybe it is. EIA economist Tancred Lidderdale said that all of that spare production capacity lies in OPEC countries, which could turn off the tap at anytime.

"Worldwide demand for petroleum is still growing faster than non-OPEC production" and that's what caused the price run-up over the last four years, said Lidderdale. Top of page

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