United States senate

**Committee on Energy and Natural Resources**

Committee Chairman: Jeff Bingaman

Washington, DC • April 3, 2008

**PREPARED TESTIMONY:**

**The Price of Oil: A Reflection of the World**

By James Burkhard, Managing Director, Cambridge Energy Research
Associates

It is an honor to address this Committee on the relationship between oil
prices and the influence of noncommercial institutional investors,
sometimes referred to as market speculators. Trading in futures markets
establishes the reference price for nearly all crude oil sold in the
world. Crude oil futures trading activity on the New York Mercantile
Exchange---the largest in the world---is currently about 350 percent
higher than in 2002.[^1] Noncommercial investors have contributed to
this increase. Growth in trading activity is coincident with a rise in
oil prices from \$26 per barrel in 2002 to more than \$100 in early
2008. The concurrence of these two trends has raised the question about
the level of influence that noncommercial investors have in oil price
determination.

What has been driving oil prices upward? It is primarily the
fundamentals of demand and supply, geopolitical risks and rising
industry costs. The decline in the value of the dollar has also played a
role, particularly in the past six months. But with noncommercial
investors playing a bigger role, the direction of a given price trend
can be accentuated. And since the credit crisis first erupted last
summer, energy and other commodities have become caught up in the
turbulence of the global economy.

**Noncommercial Investors**

The US Commodity Futures Trading Commission defines noncommercial or
speculative investors as those who are not physically exposed to the
commodity but trade "with the objective of achieving profits through the
successful anticipation of price movements." This group of market
participants includes more than just short-term speculative traders. It
represents a broad spectrum of investors with different time frames and
motivations such as mangers of pension funds, university endowments and
other institutional investors. These investors increasingly view
commodities and oil in particular as an asset class. They allocate
investment capital based upon a view of the world's need for oil and
other commodities. For example, the California Public Employees
Retirement System (CalPERS), the largest public pension fund in the
United States, recently increased the amount it could invest in an asset
class that includes commodities. This move is part of a "new strategy to
provide a hedge against inflation while diversifying investments, thus
mitigating losses during equity market downturns."[^2]

Noncommercial investors are an essential part of a futures market. In
the 1860s Chicago grain traders developed the first futures contract: an
agreement to buy or sell a commodity at a future date. Farmers were able
to offload price risk to speculative traders. In exchange for providing
price certainty to the farmer, the trader had the opportunity to turn a
profit---or a loss---from future price changes. This allocation of risk
remains the foundation of today's futures markets.

Noncommercial investors can also provide another attribute of a well
functioning futures market: liquidity. Liquidity refers to how quickly a
counterparty can be found for a transaction. The current turbulence in
credit markets illustrates the dangers that materialize when trading in
a market becomes illiquid. Uncertainty and fear come to the fore, which
exacerbates market turmoil. Oil futures markets are among the most
liquid in the world---and have remained so despite the upheaval in
credit markets.

In a sufficiently liquid market, the number and value of trades is too
large for speculators to unilaterally create and sustain a price trend,
either up or down. The growing role of non-commercial investors can
accentuate a given price trend, but the primary reasons for rising oil
prices in recent years are rooted in the fundamentals of demand and
supply, geopolitical risks, and rising industry costs. The decline in
the value of the dollar has also played a role, particularly since the
credit crisis first erupted last summer, when energy and other
commodities became caught up in the upheaval in the global economy. To
be sure, the balance between oil demand and supply is integral to oil
price formation and will remain so. But "new fundamentals"---new cost
structures and global financial dynamics---are behind the momentum that
pushed oil prices to record highs around \$110 a barrel, ahead of the
previous inflation-adjusted high of \$103.59 set in April 1980.

**New Cost Structures**

In 2004 the price of oil (in nominal terms) averaged above \$40 for the
first time ever. This was sparked by extraordinary demand growth that
reflected strong global economic expansion and a temporary surge in the
use of oil to generate power in China. Further demand growth in 2005
reduced spare oil production capacity to just 1 million barrels per day
(mbd)---compared with 4 to 6 mbd in the 1990s. Amid the whittling away
of spare capacity, political change and security worries in several
major oil exporting countries fueled anxiety about the adequacy of oil
supplies. With so little spare capacity, such fears drove oil prices
higher.

As oil prices rose, so did demand for the people and equipment needed to
find, develop and produce oil. But nearly 20 years of low oil prices and
industry consolidation meant "a missing generation"---a generation that
skipped entering the petroleum industry. As a result, major shortages of
equipment and personnel dramatically raised the cost of developing an
oil field whether in the Gulf of Mexico, West Africa or the Middle East.
CERA and IHS have developed a series of indices to measure changes in
cost---sort of a Consumer Price Index for the energy industry. Costs to
build power plants and oil refineries have surged higher. But the one
most relevant to our discussion today is the latest IHS/CERA Upstream
Capital Cost Index. This index shows a doubling of oil field costs over
the last three years. In other words, companies have to budget twice as
much today as they did three years ago. Adding to the cost pressure are
increasingly heavy fiscal terms on oil investments in the form of higher
taxes and greater state participation in oil projects. The net result is
that much higher oil prices are needed to support development of new
supplies. Some projects that in the past needed oil prices of \$20 or
\$30 in order to move forward now need price levels that are double that
amount---or even higher.

It can take ten years or more to find, develop and begin production from
a new oil field, particularly if it is large and complex. Long lead
times and the severe upturn in costs have led to one of the most
significant changes in the oil market: a steep increase in long term oil
price expectations. For nearly two decades, until 2004, expectations for
long-term oil prices hovered around \$18 to \$25 per barrel. Since 2004
the price of a futures contract to buy or sell crude oil five years out
has risen steadily. It topped \$100 per barrel this year. Five years is
considered long-term from an oil market perspective as opposed to the
longer times that can be required to develop a new oil field. The
sustained breakout of oil prices from a relatively narrow historical
range along with global financial dynamics has fostered greater interest
in oil among financial markets.

**Global Financial Dynamics**

The oil price has long reflected major trends in the economy and
geopolitics. Rising inflation, a rush to invest in commodities and
worrisome tension between the United States and Iran drove oil above
\$100 per barrel in real terms in 1980. In 1998 the price of oil
collapsed largely because of the fallout from the Asian financial
crisis. Today, two major trends that are reflected in the price of oil
are the decline of the dollar and the rising economic clout of many
regions outside the United States.

*Oil and the Dollar: The New Gold*

The effect of a declining dollar on the price of oil first became
prominent in early 2005. The dollar had fallen about 35 percent relative
to the euro since 2002. OPEC generally imports more from Europe than the
United States, so a weak dollar damages terms of trade from OPEC's
perspective. The falling dollar contributed to the lifting of OPEC's
implicit oil price objective, which altered market expectations about
price and the balance between demand and supply. The price of oil was
nearing \$50 per barrel---a very high price at the time.

In the past half year lower interest rates and anticipation of further
cuts in interest rates pushed the dollar lower. Amid great turbulence in
credit and other financial markets, the nature of the weak dollar's
influence on the oil market changed. Oil has become the "new gold"---a
financial asset in which investors seek refuge as inflation rises and
the dollar weakens. This may seem counterintuitive at a time of weak oil
demand in the United States, but today's dynamics in the marketplace
reveal oil's increasingly cosmopolitan nature. The price of oil reflects
not only demand and supply, but broader macroeconomic and geopolitical
changes such as the growing influence of Asia, the Middle East, Russia
and the Caspian countries.

Strong economic growth outside the United States has not only supported
growing oil demand but also propelled rising demand and prices for many
commodities. In addition to energy, food prices are surging around the
world. According to the International Monetary Fund. global prices for
cereals---wheat, rice, corn (maize), and barley---increased 82 percent
from 2000 to 2007. More than half of this increase has been in the past
two years. Recent data from China show food prices pushing overall
inflation to 8.7 percent---the highest level in more than a decade.

A key element of the "oil as the new gold" story is the expectation that
demand for oil will continue to grow, and thus be able to hold its value
despite a weak dollar and rising inflation. To a degree, an expectation
of a strong oil price is a bet on the future of China and India. The
United States is the world's largest oil consumer, but 75 percent of
global demand is outside the United States. For example, since the
beginning of 2007 eight of the ten largest oil markets in the world
(excluding the United States and Saudi Arabia, whose currency is pegged
to the dollar) have seen significant currency appreciation ranging from
9 percent (India) to 19 percent (Brazil). When a currency appreciates
against the dollar, it diminishes the impact of an increase in the
dollar price of oil in that market. Also, regulated prices of gasoline
and diesel in some key markets means that consumers are not exposed to
the full increase in the global market price of those products. This
places pressure on government and company budgets, but if a given
country enjoys strong economic growth it can withstand, at least for a
time, rising oil prices.

**Outlook**

If economic and oil demand growth remain vibrant in large markets around
the world and the dollar continues to weaken, then financial dynamics
could continue to drive oil prices higher. But oil's role as a financial
hedge does not mean that its price will rise continuously. Prior to the
ascent in recent years, both gold and oil prices had been mired in
long-term price slump. In the late 1990s, \$100 oil---or even \$80
oil--- seemed preposterous. Today, \$20 oil seems quaint.

The political and manpower difficulties currently constraining oil
supply growth will not disappear overnight. The desire for higher living
standards in China, India, the Middle East, Russia and elsewhere will
remain as strong as it was in Europe, Japan and the United States in the
post World War II years. Higher living standards mean longer life
expectancy, lower infant mortality---and higher energy consumption.

But just when the future seems preordained in the oil market, the
unexpected can unfold. It did in the decade following 1998, just as it
had several times since 1970. This year will be a stiff test for the new
oil price era that dawned on the world several years ago. Economic
growth is the single most important determinant of oil demand
growth---and the course of the global economy in 2008 is fraught with
worries.

Financial innovation and the globalization of securities helped to
lubricate the wheels of the global economy during an extraordinary
expansion, but it also created risks that were not---and still are
not---fully understood. The US subprime mortgage meltdown is the most
current example of misunderstood risk, but is it the last?

Oil prices can remain high during an economic downturn. In the early
1980s, one of the weakest periods of economic growth since the
depression of the 1930s, oil prices were at very high levels for several
years. But eventually, the economy and demand catch up: the 1986 oil
price collapse was due to a multiyear decline in oil demand.

This year, just as economic worries began to mount, oil prices touched a
new high of about \$110 per barrel. Although oil prices are only one
factor affecting the global economy, they are a significant one. Because
the world economy took \$70 per barrel in stride does not mean that it
would easily absorb \$100. If prices hover in the \$90-\$100 plus range
for six months or more, then it would be increasingly difficult to argue
that high oil prices do not have a significant impact on economic
growth. Moreover, given the growing use of corn-based ethanol, oil
prices are now connected to food prices, which are rising. And the
increase in food prices is a major source of inflation in many emerging
markets around the world. Oil prices are fluctuating in line with the
latest economic signals---up and down. This will continue until a
clearer view of economic growth materializes. But one factor is clear.
The price of oil will reflect major swings in the value of the
dollar---both up and down.

*James Burkhard, Managing Director of CERA's Global Oil Group, leads the
team of CERA experts that analyze and assess oil markets and strategies.
His team also develops and maintains detailed short- and long-term
outlooks for global oil supply and demand. Mr. Burkhard\'s expertise
covers geopolitics, world economic conditions, and global oil demand and
supply trends. Mr. Burkhard was the project director of Dawn of a New
Age: Global Energy Scenarios for Strategic Decision Making---The Energy
Future to 2030, CERA's comprehensive study encompassing the oil, gas,
electricity and renewable energy sectors. He is also the coauthor of
CERA's respected World Oil Watch, which analyzes short- to medium-term
developments in the oil market. In addition to leading CERA's oil
research, Mr. Burkhard served on the US National Petroleum Council (NPC)
committee that provided recommendations on US oil and gas policy to the
US Secretary of Energy. He led the team that conducted the energy demand
analysis and developed the demand-oriented recommendations that were
published in the 2007 NPC report Facing the Hard Truths About Energy.
Mr. Burkhard holds a BA from Hamline University and an MS from the
School of Foreign Service at Georgetown University.*

[^1]: The figure of 350 percent represents the increase in open interest
    in NYMEX crude oil contracts, which is a proxy for levels of trading
    activity. Open interest is defined by the US Commodity Futures
    Trading Commission as "the total number of futures contracts long or
    short in a delivery month or market that has been entered into and
    not yet liquidated by an offsetting transaction or fulfilled by
    delivery."

[^2]: CalPERS February 19, 2008 press release.