Oil Consultants ESAI: Oil Prices Are Inflated, Will Drop Soon

Posted by Jared Killeen on October 27, 2009 at 9:06 am

(image: esai.com)

Lately there has been much conjecture on the price of crude oil. Is the recent spike a sign of economic recovery or just another financial bubble overblown by speculation? Adding its two cents is Energy Security Analysis, Inc (ESAI), a Massachusetts-based energy consultancy firm that published a well-considered analysis of the oil market, published by Reuters as an opinion piece on Friday. According to ESAI, over-eager speculators risk creating a “bull trap,” in which oil prices continue to rise precipitously until they exceed all reasonable expectations, at which point the scale tips and prices plummet. If this sounds familiar, that’s probably because last year’s mortgage crisis began in much the same way.

With dutiful restraint, the ESAI predicts that upward-creeping OPEC output and weak demand will result in a surplus of oil stocks this winter. That is, with demand down and supply up, oil prices should stay low. However, the good folks at ESAI worry that speculators will ignore such warning signs and continue to overestimate the value of oil. According to several sources, there are two big reasons for a bullish oil market: a weakening dollar and an exaggerated confidence in a quick financial recovery. 
It’s no secret that the US dollar is in bad shape. What’s not as widely known is that as the dollar falls, oil prices go up. This is because crude oil is priced in dollars, as are many of the world’s most precious commodities; thus, as US currency loses value, it takes less foreign currency to buy a barrel of oil. A declining dollar has already helped bring oil up to $80 per barrel, and as energy consultant Geoffrey Styles warns, we could see this price reach $100 per barrel before long. According to the ESAI, the dollar has suffered under short-term expectations of inflation and long-term fears that it will not be the world’s reserve currency for very much longer. The dollar index, which charts the value of the dollar against other major currencies, fell below 80 in May of 2009 for only the second time since the US abandoned the gold standard. Needless to say, this does not bode well.

Also driving up oil prices is the misconception—common among some investors—that the US is well on its way to a full economic recovery. As the ESAI points out:

strong results from Intel and other bellwether companies, along with more bullish economic outlooks from the IMF and other multilateral institutions, are creating a narrative of a global economy already recovered.

Although many doubt it’s likely that the economy is back to its old robust self, a speedy recovery would mean that businesses would begin to produce and ship more products, and thus would begin using more oil and gasoline to power their trucks and ships. In other words, an improved economy would mean higher demand for crude and gasoline. Analysts like Dan Burrows at Daily Finance, however, suggest that much of these hopes are founded on speculation; while James Cordier, president of Liberty Group Trading Group, has said that oil is “enjoying incredible momentum and piggybacking on the stock market for the last several weeks, especially with the Dow going over 10,000.”

Perhaps the most convincing suggestion that oil prices have risen too high comes from OPEC itself, an organization that should be happy to see prices go up. Last Wednesday, the Secretary General El-Badri admitted that OPEC alone produces 6 to 7 million excess barrels per day, and still holds 125 million barrels of oil in floating storage; given the fact that supply far exceeds demand, El-Badri conceded that prices are excessive: “We are seeing an $80 oil price that is a little too high” because there is “no shortage of oil supply.” If that’s not good enough to bring the price of oil down, what is?

In fact, many analysts and investors have joined ESAI in pointing out that price declines may be more likely than speculators believe. After all, if crude supplies remain high, then prices can only increase so much. As Michael Lynch, president of Strategic Energy & Economic Research, recently cracked, “There’s so much oil out there that people are going to start using it on their pancakes.”  Furthermore, there is much dispute concerning the state of the global economy, and opinion seems to swing almost every day. Indeed, HeatingOil.com reported on Monday that oil prices declined as investors worried that the global economy had not recovered enough to justify higher prices.