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How High can Crude Oil Fly?

Gary Dorsch
July 19, 2007
Global Money Trends newsletter

In London, the price of North Sea Brent, the benchmark for two-thirds of the world’s oil, touched an all-time high of $78.40 per barrel this week, with no sense of alarm at the world’s top central banks. Regarded as a key indicator of global inflation, central bankers are sitting in stone faced silence about the surge in crude oil, and that’s been good news for bullish speculators in gold and energy shares.

After all, higher interest rates won’t produce one extra barrel of oil. When asked about the high price of crude oil on July 10th, Federal Reserve chief Ben “helicopter” Bernanke replied, “Inflation is less responsive than it used to be to changes in oil prices and other supply shocks. If inflation expectations are well anchored, changes in energy and food prices should have relatively little influence on “core” inflation.”

Crude oil has been on a wild roller coaster ride for the past 18-months, gyrating within a wide range, between a low of $50 per barrel and a high of $78 /barrel, and dragging global oil company shares along for the ride. With the Dow Jones Industrials hyper inflating to the 14,000 level, and oblivious to record high oil prices, why should US central bankers rock the boat with higher interest rates?

Brief Historical Perspective on Crude Oil

In today’s world of 20-second sound bites, and information overloaded with lots of static and noise, it’s easy to lose one’s historical perspective on the markets. The starting point for the latest six-month rally in North Sea Brent was from the depths of despair, at $51 per barrel. So after a 50% increase in oil prices to record highs of $78.40 /bl for Brent, traders are asking just how high can crude oil fly, or does a big tumble lie ahead for the second half of 2007?

It was one year ago to the day, when Iran’s proxy in Lebanon, the Hizbollah terror network, sent a commando unit across the border into Israel and ambushed an Israeli patrol, killing eight soldiers and kidnapping two. The raid sparked a swift Israeli response, including the bombardment of Hizbollah strongholds in Beirut and a 34-day blockade of Lebanon by land, sea, and air.

For the first three days of the war, the world held its collective breathe, wondering if Iran and Syria would jump into the fray, and trigger a wider war in the Middle East, that could send crude oil prices soaring. On July 30th 2006, Venezuela’s oil minister Rafael Ramirez threatened to cut off oil exports to the US, if President Bush used the Israeli- Hizbollah war as a pretext to attack Iran’s nuclear installations.

The Israeli - Hizbollah skirmish did lead to a “war of words” between US President Bush and Iranian leaders from the sidelines, but none of the tough rhetoric materialized into action. Once it became apparent that Israeli PM Ehud Olmert could not engineer a crushing defeat of Hizbollah, the US and other Western powers asked for a UN cease fire, which ushered in a huge slide in the crude oil market.

Few operators in the crude oil market could have imagined that North Sea Brent would tumble by $27 per barrel, losing more than a third of its value, to as low as $51 per barrel by January 2007. But behind the scenes, the OPEC cartel kept its oil output steady at 28 million barrels per day, near a 25-year high, greasing the skids in crude oil and aiming for a “reasonable target” of $60 per barrel.

Once crude oil tumbled to the $60 / barrel range, Saudi Arabia and Kuwait sent signals to the media, in support of production cutbacks to stabilize oil prices. On October 20, 2006, OPEC agreed to curb its output by 1.2 million barrels per day, its first cut for more than two years, to halt the precipitous fall in prices. But crude oil continued to plunge in January to as low as $51 per barrel, when it became apparent that OPEC was cheating on its pledge to cut oil supplies.

Since hitting rock bottom at $51 /barrel, the pendulum has swung the other way with North Sea Brent oil prices climbing upward to record highs of $78.40 this week. A booming global economy, led China and India, the unexpected loss of 1.2 million bpd of crude oil exports from Mexico and Nigeria, and OPEC’s output cutbacks of 1.2 million bpd, paved the way for the historic rebound in oil prices.

Global demand for crude oil is led by China and its 11% economic growth rate. China’s crude oil imports were up 20% in June from a year earlier to 14.1 million tons. In the first half of this year, China’s oil imports rose 11.2% from the same year-ago period to 81.5 million tons. China has become Iran’s biggest customer, buying 15% or 335,000 bpd of Iran’s oil exports last year, and Beijing uses its UN veto to blunt Washington’s drive to squeeze Iran’s oil industry and economy.

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Gary Dorsch
July 19, 2007

Global Money newsletter

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