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Oil supply, demand set on a hair trigger

Prices continued a weeklong plunge on Monday, as big traders pulled back on positions predicting higher prices ahead. Crude oil prices have reeled after good news from Russia, bad news from Iraq and speculation about what it would take for the White House to unleash the Strategic Petroleum Reserve.

Since flirting with $50 per barrel on Aug. 20, crude oil traded on the New York Mercantile Exchange has been falling and closed Monday at $42.28.

The last week and a half have been a welcome respite in a summer of soaring prices, but crude oil prices are still up 30 percent for the year.

Larry Goldstein, president of the Petroleum Industry Research Foundation in New York, says the recent price drop is an opportunity for the market to catch its breath, but he doesn't expect the peace to last long.

Why all the volatility? Today's tight oil market is set to a hair trigger.

Global oil consumption is 82 million barrels a day and growing fast. But virtually all oil-producing countries are already pumping as much crude as they can.

OPEC member nations have started to call for increased production, but even Saudi Arabia, long considered the world's swing producer because it has had more spare capacity than anybody else, has almost none left.

With virtually no supply cushion and no signs of demand going slack, anything that crimps supplies will lead to another price spike.

"Surprises are an everyday event," Goldstein says. "The market has done all it can, so I'm nervous about the next surprise. When it occurs it will send prices right back up again."

Goldstein said hedge funds, which cater to wealthy investors willing to take big risks to reap high returns, and other speculative buyers of oil have inflated oil past justifiably high prices this summer.

"Speculators are responsible for pushing it right through $40 and to nearly $50," he says.

Last week many speculators switched course, shorting the market. Short sellers are betting oil prices will fall. Monday's trading continued that trend, with more noncommercial traders shorting oil than at any other point this year.

Trying times
London-based Jan Randolph, chief economist for World Markets Research Centre, doesn't blame speculators for taking advantage of oil. After all, hedge funds exist to make money out of the wild price swings that come with difficulty, he says.

Neither does Randolph blame countries in Asia for wanting to develop. Emerging middle classes in places like India want all the same creature comforts most Americans and Europeans enjoy, whether electric appliances or cars. It all requires fuel, which could mean tight supplies for years to come.

"In some ways, we're living with the problems of our success," he says.

Randolph says every time he looks into the future, he gets worried. If global oil demand grows by 2 percent annually on average — a conservative estimate, he thinks — the world's oil consumption is going to jump from 80 million barrels a day to more than 110 million barrels per day by 2020.

"Beneath all the price drama of the day, where are we getting our oil from in the future? We have to go to the Middle East because that's where it is," he says. "So we have to ask ourselves whether we really want to get involved in politics in places like Iraq and Saudi Arabia and Iran."

No recession yet
Stephen Brown, director of energy economics at the Federal Reserve Bank of Dallas, says the public's nerves get jangled by high oil prices because nine of the last 10 recessions since World War II were preceded by sharply rising oil prices.

What the public forgets, he says, are the four price spikes in 1987, 1989, 1994 and 1996 that weren't followed by recessions.

Economic research does show persistently rising crude prices hurt the economy more than falling prices help it. Brown sees this round of price spikes stunting U.S. prosperity but not sending the country into a downturn this year.

According to the Bureau of Economic Analysis, oil-related costs shaved three-tenths of a percentage point off GDP growth in the second quarter. Thanks in part to high oil prices, GDP for the year will probably grow between 3 percent and 3.5 percent instead of the 4 percent to 4.5 percent predicted back in January.

Globally, demand doesn't appear to be slowing down, and long-term traders seem to agree. Brown says the market still thinks the supply-demand equation will be tight for years to come, and points to oil futures set for delivery in December 2010 that are trading around $33 per barrel, up sharply from $23 this time last year.

OPEC members seem to be waking up to this new demand reality and have publicly started to call for more foreign investment to expand crude production capacity.

The latest to ask for outside help is Iran, with Deputy Oil Minister Mohammad Hadi Nejad Hosseinian saying the country has set a target a producing 5.5 million barrels of oil per day by 2010 but needs a $50 million injection of capital from foreign investors to do so.

Some analysts say it's unlikely Iran will be able to draw that capital without significant policy changes to make investing there more attractive.

Editorial Notes: The warning of a 'three to five year' rollercoster ride the only novelty in this article. No suggestion as to where the reserves are going to come from at the end of the five years. -LJ

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