Why $120 oil is good

Speculators are often blamed for artificially inflating crude prices, but some experts say high prices are needed to cut demand and develop new resources.

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By Steve Hargreaves, CNNMoney.com staff writer

When it comes to the economy, I feel:
  • The worst is over
  • It will be up and down
  • It's going to get worse

NEW YORK (CNNMoney.com) -- With $120 oil not seeming to follow the fundamental law of supply and demand many are wondering if the market is broken.

The Federal Reserve has been cutting interest rates, saving Wall Street but sinking the dollar and driving up food and fuel prices. Investors, also called "speculators" by some, have been pouring money into commodities of all sorts, artificially driving prices higher in an attempt to squeak out healthy profits in the face of falling stock values.

But to many, all the financial voodoo is merely a distraction. The fundamental reality of oil - and the thing that makes it so attractive to investors in the first place - is that we are using ever more and finding ever less. High prices are necessary if we are to reduce demand, find new oil, and develop alternative technologies.

"The market is starting to send a signal: You got to get your alternative in line," said Robert Kaufmann, director of Boston University's Center for Energy and Environmental Studies. "Societies that ignore this kind of signal do so at their own peril."

Kaufmann isn't promoting the so-called "peak oil" theory - he doesn't think the world is quickly running out of oil.

The problem, he says, is new discoveries of crude in non-OPEC areas like the United States, the North Sea, and Russia have not kept pace with the oil being removed from those places. OPEC, which holds two thirds of the world's crude oil reserves, has seen no drop in global demand despite $120 oil and has little incentive to increase output.

It's this supply problem that prompted analysts at Goldman Sachs to reaffirm their prediction of a so-called "super spike" in oil prices - which could usher in $200-a-barrel crude in the next 6 to 24 months.

"We believe the current energy crisis may be coming to a head, as a lack of adequate supply growth is becoming apparent," Goldman analysts wrote in a research note Tuesday.

That's the supply side of the equation. The demand side is a familiar story - developing regions like China, India and the Middle East are using more and more oil. It's not that this wasn't known last year - when oil was half as expensive as it is now - it's just that the world is moving closer to that tipping point where demand will exceed supply.

'It's a finite resource," said Brian Hicks, co-manager of the Global Resources Fund at U.S. Global Investors, a San Antonio-based mutual fund. "The rest of the world wants to live like we do, and there aren't enough resources to keep everyone happy."

It's become popular to blame speculators - which would include mutual funds, pension funds, some banks, and anyone else who doesn't ultimately take delivery of a barrel of oil - for the run up in price. Congressman have recently spoken of an "orgy of speculation" in the commodities markets, and have held hearings into the matter.

But most analysts say investors are simply looking at these underlying supply and demand trends and buying oil because they see it going up on its own accord.

After all, they can't really be influencing the price of crude, the argument goes, as they generally don't take delivery of the oil and must sell whatever contracts they have at the end of each month. Ultimately, they don't take any oil off the market.

"Nobody at Goldman Sachs wants to see a fuel truck pull up and say "Ok, here's your 60,000 gallons of gasoline,'" said Michael Cosgrove, president of the commodities brokerage Amerex Brokers, which handles transactions for both banks and end users of oil like refineries. "Ultimately, it's the consumer."

Which is one reason why $120 oil is necessary - to limit demand in a supply-constrained world.

"I think the market is working," said Joseph Stanislaw, an independent energy adviser at the consulting firm Deloitte & Touche. "It forces us to make decisions as individual consumers that will change our behavior. It needs to be done."

Government regulators at the Commodity Futures Trading Commission have also said their studies have produced no evidence that oil speculators are significantly driving up the price of crude.

The argument that speculators aren't unduly influencing oil prices is by no means universally accepted.

"I think the market is totally insane," said Fadel Gheit, a senior energy analyst at the investment firm Oppenheimer. "Somebody is playing a game, and we're all paying for it."

Gheit said demand has fallen in developed countries, and there is plenty of energy supply - mostly in the form of natural gas - available right here in the United States, if only the oil companies had access to it.

Some analysts and politicians have called for increasing the nations oil production by drilling in areas that are currently off limits - like the Arctic National Wildlife Refuge, sections of the Rocky Mountains and off the east and west coasts.

"If we opened access to gas in this country, we wouldn't need oil in five years," he said.

Both sides in this debate make concessions.

The "market-is-working" types agree that the discovery of oil as an investment class is probably driving up prices somewhat - perhaps by as much as $30 a barrel - although they maintain the long-term price trend would be little changed absent these speculators.

And Gheit agrees that higher prices do provide much-needed incentive to limit demand.

"I've long said maybe the best thing that could happen to this country is to have $6 gasoline," he said.  To top of page

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