Here is an interesting question:
Why is oil $75 a barrel?
When you look at supplies, production, consumption, estimated growth in each of these, refining capaticy, and all the other
factors that go into why oil is at a price level, the general consensus is that oil right now, should be at $50-$60 a barrel. Some estimates are higher, some are lower. And yet, the price of oil is at $75 a barrel. It just set a record high close last week. The 250 day moving average (there are about 250 trading days in a year, so its about a years worth of data) is at $64.76 a barrel. With such a long average, this is much higher than the consensus.
WHY?
Well, these analysts say something like this:
'There is a geopolitical risk premium added into the price, which is making the price of oil higher than it should be right now. Once this risk premium is eliminated, the price will fall to a level more in line with the underlying fundamentals.'
Hmmm... Geopolitical risk premium. Why would this be the case? What is causing this risk premium to be added?
It is a pretty substantial risk premium, don't you think? If we take $55 a barrel as the expected price, our risk premium adds about 35% (!) to the price of oil and its refined products. That is quite a large price to pay for uncertianty. And this risk premium been sustained over the course of a full year. Thats a long time.
So - we have two questions that follow out of that first question.
One: Why is the risk premium so large?
Two: Why has it lasted so long?
We can discuss these questions at the same time, as they have roots in the same phenomenon. And that is George W. Bush's foreign policy.
We have come to a place where the markets have looked at Ws policy and voted - they don't like it. They are scared and skittish about being short oil. That is, natural consumers of oil who need to buy oil are natural shorts and they are afraid that they will be stuck without reasonably priced oil, so they are willing to pay much more than necessary to insure the supply of oil. The market participants who would typically take this overpriced oil and sell it down to a more reasonable level are scared about supply disruptions and will not sell without protection. In this case, protection is a 35% premium to a fair price.
However, we have a conundrum. Yep, a real live conundrum. Say it again. The high price of oil is in many ways reinforcing the geopolitical risk. For example, about once a week, you might hear about China and how they are going to compete with us for oil, and may even start a war over it. This is a small risk, but we still talk about it.
If oil were priced at $50/barrel, this risk would be less. The high price of oil greatly increases this risk that is due to the high price of oil.
Our issues with the middle east, Iraq, Iran, they are all dependent on the fact that they supply so much oil. Since the price of oil is so high, these geopolitical risks are amplified. However, these geopolitical risks are responsible for a 35% increse in the price of oil.
This is very similar to what George Soros means when he talks about reflexivity. Before Mr. Soros was a massive supporter of Democracy here and in the former Soviet bloc countries, he was the greatest trader that ever lived. Hes tried to explain why and how he made his money, and he said that he looked for situations that were self-reinforcing. Situations where the factors that were important fed on each other, where higher prices would lead to higher because of other market concerns. He made many great currency bets like this, the most famous being his bet against the bank of England. Much like the Nasdaq bubble, much like our current housing price bubble - these are textbook examples of reflexivity.
So why is W all responsible and all that? Well, he is probably the only actor on the world stage who has the power to substantially lower the geopolitical risk. We don't have the ability to lower the price of oil.
He is directly responsible for Iraq and our tensions with North Korea. He won't back down from these situations, and as long as he remains stubborn, the oil market is going to remain stubbornly above $65 a barrel, with higher spikes.
His behavior is going to determine our oil prices to a large extent, as long as he is in office. We may see a drop in price around the time of the '08 elections.