Behind Oil’s Surprising Surge

OPEC production cuts and hedge fund money have lifted oil prices. And fears about a falling dollar could push them higher

London—It seems like a paradox: Demand for oil, which almost always rises, is likely to drop by 3% in 2009—the worst decline in almost 30 years. Stockpiles are so high that an ocean of oil is building up around the world in tankers or in depots. Yet since hitting a low of $34 per barrel on Feb. 12, the price of light, sweet U.S. crude has more than doubled, to $71 per barrel. Why are prices soaring?

OPEC officials and oil traders say that market sentiment has changed dramatically. Investors, who dumped oil last fall, are no longer deterred by the prospect of a glut. Instead, with extreme pessimism about the world economy giving way to cautious optimism, markets are reverting to last year’s worries about future supply shortages. “Hedge funds and asset managers who have been sitting on cash now feel it’s time to buy [oil],” says Göran Trapp, head of global oil trading at Morgan Stanley (MS) in London. Some $3.8 billion has flowed into oil and gas exchange traded funds this year, vs. $1.4 billion in the first half of 2008.

OPEC has played a big role in lifting prices. Spooked by last fall’s price collapse, the producers’ club announced 4.2 million bbl. per day in cuts and is doing a better job than usual sticking to quotas. Even typically recalcitrant Venezuela and Iran are curbing output. OPEC leaders such as Saudi Oil Minister Ali Naimi have been effective at convincing the market that the Goldilocks oil price should be $75 to $85 per barrel. They argue that it’s the right level to give the oil industry an incentive to invest in projects while not strangling a potential economic recovery. That price “is very attractive, like a magnet,” says Roger Diwan, head of the hedge fund practice at consultant PFC Energy in Washington.

Worries about the falling dollar and rising inflation are also a driving force

Commodities like oil, along with currencies such as the euro and British pound, are seen as good hedges against a possible collapse of the greenback under the weight of mushrooming U.S. debt. David Woo, an analyst at Barclays Capital (BCS) in London, believes the world is starting to see a reprise of last year’s trend, when rising oil prices and a falling dollar fed off each other, pushing both to extremes.

Could oil prices surge out of control? That may not be the likely scenario, but it’s certainly possible if the recovery is strong and anxieties about the dollar and oil supplies intensify. Jeffrey Currie, a Goldman Sachs (GS) analyst in London, has boosted his yearend 2009 forecast to $85 per barrel. In his view, recent price rises are just the first stage in a powerful rally to be generated by renewed global growth. Amrita Sen, a Barclays Capital analyst, thinks the ceiling is about $100 per barrel. At that point, Saudi Arabia, Kuwait, and the United Arab Emirates “will quickly turn the taps back on,” she says.

Prices could fall if the bullish mood fades. And many observers think prices are ahead of where they should be. Even some OPEC officials believe a price closer to $50 is realistic in today’s economic climate. The current price “is all based on perception,” said a senior delegate at the recent OPEC meeting in Vienna. For the moment, though, that thinking isn’t influencing money managers eager to invest their cash.

Reed is London bureau chief for BusinessWeek.