Oil price? Check the weather
Increased global demand and dwindling reserves play their role, but don't forget the effect of weather in determining oil costs, argues Fortune's Telis Demos.
NEW YORK (Fortune) -- Need a new barometer for the price of oil? Try a weather report.
Like most commodities, oil is seasonal in the most literal sense - in the winter, we consume more heating oil. In the summer, we drive more and use more gasoline. The price rises and falls with the season every year, even though markets see the increased demand periods coming.
But in the gush of commentary dissecting $100 barrels of oil, it seems like the weather is a forgotten factor. The headlines following last week's release of the International Energy Agency's influential Oil Market Report focused on the big picture: Rising consumption from India, China, and other developing nations on the demand side; a tougher search for new sources of crude oil on the supply side.
Such megatrends aren't something the markets have just learned, and they do explain a big part of the price of oil. But they hardly explain everything, and especially not all of the recent extreme volatility as we've watched prices zoom from $70 in August to almost $100 last week.
Analysts say it's worth looking at inventories of oil tied to seasonal, weather-driven demand. That drives the more immediate supply that oil traders and buyers are looking at when pricing it. And while nothing sort of a miracle could bring us back to $20 oil, a mild season could help bring prices back to their recent averages.
So looking at the price of oil through a seasonal lens, how did we get to where we are today? Inventories built up from last year's unusually mild winter in the northern hemisphere - where about 90% of the world's oil is consumed - glutted the market with crude starting in January. The price fell as low as $50.48 on Jan. 18. As the year went on, that glut helped tamp down prices - it hovered around $65, the average since 2005. Inventory in the U.S. alone - which consumes about 30% of all oil - was 20 million tons higher in July of this year than it was last year, even adjusted for the overall increase in demand.
But starting in October, U.S. inventory actually dipped below last year's mark and prices crossed into record heights. Oil started at $80.05 per barrel on Oct. 1. Friday's close was $96.32. "As we've gone through this year, we've had that excess inventory from the last quarter of last year," says Mary Novak, energy risk analyst at Global Insight. "And it took us until early October to run through that stockpile."
The end of that supply glut, combined with overall falling production in non-OPEC countries and among the oil majors - crude production at ExxonMobil (Charts, Fortune 500) dropped 2%, BP (Charts) fell 4.3%, and Royal Dutch Shell (Charts) fell 3.5% - are making things very tight this winter. "Crude oil inventories would normally be expected to be in the process of completing a seasonal rise at this point," writes Barclays analyst Paul Horsnell in a recent report. "But they have instead fallen."
While weather doesn't account for all of the price, or even all of the volatility (don't forget political tensions in Turkey and Pakistan and the dollar's rollercoaster), it is a leading indicator worth watching. "If we get a cold snap in the first week of December, prices could easily go over $100" as demand soars, says Novak. "Otherwise, they'll stay where they are until the threat of a cold weather is gone."
What's the outlook right now? The current weather forecast is for a mild season. "Observations of a very moderate La Niña storm suggest a warm winter," says Brian O'Hearne, a weather risk analyst at Swiss Re Capital Management and Advisory. "The energy market is geared for slightly warmer weather." The futures market reflects a belief prices will fall: contracts January delivery of oil are trading consistently at $1 below the benchmark immediate-delivery contracts.
There's already downward pressure, as oil retreats from last Wednesday's $98.62 peak, closing at $96.32 last Friday. Once the final winter verdict is in, prices will make a big move, especially downward if the weather is mild. "Usually the speculators leave late December or early January," says Global Insight's Novak. "We'll get another read on the true fundamental price of oil around then."