December 22, 2010

Oil Prices and Inventories

This chart from the Wall Street Journal shows that oil inventories steadily rose despite the gyrations in the oil price from 2007 to 2010. This suggests that the introduction of new commodity funds into the market has played an important role in fostering price increases.

Notes the Journal:

In the market for oil futures and options, investors such as hedge funds and exchange-traded funds have been piling into contracts that rise in value with prices. As of Dec. 7, their bullish bets exceeded their bearish bets by about 223 million barrels, the highest level on record.

In the physical market, oil producers have ample capacity to keep prices in check. The International Energy Agency estimates spare capacity among Organization of Petroleum Exporting Countries at 6.4% of global demand, nearly double the level of late 2007. As of the end of November, the world had enough oil in its inventories to cover demand for 20 days without drying out pipelines and refineries, according to data provider Oil Market Intelligence. That's up from 14 days in November 2007.

Thanks to the added inventories, "the broader economy is now more insulated from oil shocks" than it was back in 2008, says Philip Verleger, an energy economist at the University of Calgary's Haskayne School of Business.

While many see speculative investment as a source of volatility, it might actually help prevent a spike, says Mr. Verleger. By pushing up the price of oil to be delivered in future months, investors have made it more attractive for traders to buy oil now and hold it for future sale. That, in turn, keeps inventories higher, providing a cushion that can limit price swings in the event of sudden changes in supply and demand.

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