What's Behind the Crude Oil Spike to $112 and Why There's More to Come

By: Money_Morning

Kent Moors, Ph.D. writes: Crude oil prices rose for the third straight day yesterday (Thursday) - with more of the same to come.

West Texas Intermediate (WTI) crude for June delivery rose to $111.50 a barrel on the New York Mercantile Exchange, and traded as high as $112.48, the highest intraday price since April 11. Crude prices are up by a full third so far this year.

Brent crude is trading at $123.70 a barrel on the ICE Futures Europe exchange in London.

The latest surge in oil prices is not a result of new geopolitical developments - although they continue to weigh on the market.

Nor is it a result of any short-term inventory problems in either the United States or Western Europe. In fact, available supply of both crude oil and finished products continues to run considerably above five-year averages. American stockpiles are now at multi-year highs.

This spike is our introduction to a very quickly changing oil sector - one in which demand is coming from new quarters, and concerns are increasing over sufficient balance among regions.

The New "Oil Dynamic"
It has been some time since the Organization for Economic Cooperation and Development (OECD) countries - essentially Europe, North America, Australia, Korea, and Japan - have actually controlled this market. Demand now comes from developing, not developed, economies.

This has created a new oil dynamic that is playing an increasingly growing role in crude oil prices.

What occurs on a day-to-day basis in the United States - still the largest end-user market in the world - has a declining impact on price. This affects both crude oil and finished products such as gasoline, diesel, high-end kerosene (jet fuel), and low-sulfur heating oil.

There is an important point to remember from all of this: The global oil market is highly integrated.

Regardless of how much surplus inventory may exist in an individual national economy, prices for gasoline (or diesel or heating oil or jet fuel) are still fundamentally driven by what occurs elsewhere in the world.

Neither "Drill, baby, drill" nor "Fortress America" will have the impact their proponents anticipate. In fact, the idea that domestic crude oil can reduce gasoline prices is fundamentally incorrect.

Domestic crude is considerably more expensive to extract than oil imported from elsewhere. And since the cost of crude oil is the single-largest component in the cost of refining, having the source closer to home does not translate into less-expensive refined products.

Now if this had been a national-security argument, pricing considerations would take a secondary seat.

If we were talking about a national security strategy, the objective is to bring crude oil supplies under control; price is not a consideration.

If Americans were to accept paying more at the pump (and we are talking way more here - well over $5 a gallon, as we will see in a moment) as a necessary cost of weaning ourselves from Middle East sourcing, then the solution would be simple.

Unfortunately, it is the pricing side that captures the attention.

And if we are concerned with the price of oil and gasoline, diesel fuel and other fuels, with the net impact of rising oil prices on the U.S. economic recovery, and the risk that those higher costs pose to U.S. jobs, the American tax base, and the country's industrial infrastructure, then importing from abroad becomes the cheaper option. 

The security/pricing tradeoff is both the most all-encompassing and the most politically misused element in the entire energy debate.

Yet it does bring the real issue into focus.

Domestic Crude Oil Production Is Unrealistic
An important rule of thumb holds that each $1 increase in the price of a barrel of crude oil translates, on average, into a 2.5-cent increase at the pump for a gallon of regular gasoline, and an increase of as much as 3.2 cents for a gallon of diesel.

Let me put into perspective what this means for domestic U.S. production.

During the second week of July 2008, when oil prices hit $147.27 a barrel, with gasoline costing an average of more than $4.20 a gallon nationwide (and diesel more than $4.60 per gallon), there were more than 360,000 capped wells in West Texas. And those wells held, in aggregate, millions of barrels of crude oil.

But even with oil at $147.27, it was too expensive to open them up. These are "stripper wells," the source of more than 60% of the crude pumped daily in the U.S. market. Each well provides less than 10 barrels of oil a day, but upwards to 200 barrels of water.

And that disproportionately increases the cost of extraction.

At the time, I estimated it would take a price of $183 a barrel to make these wells profitable enough to allow an oil flow. That $35.73 price difference (between the actual record price of $147.27 and the required $183) would have catapulted gasoline prices to an average of $5.09 and diesel to $5.74 per gallon. And that was almost three years ago.

It is little wonder, then, that the United States is experiencing a rise in imported gasoline and other oil products. It is becoming cheaper to refine them abroad.

This is the real reason we will not see new refineries built in the American market.

The actual barriers to new refineries are not environmental regulations or "NIMBY" (not in my back yard) sentiment. Rather - even forgetting about the billions of dollars in expenses involved - it would take about a decade to bring a new refinery on-line from scratch. Well before that period expires, the more cost-effective approach is simply to import what additional oil product is needed.

So the current spike in oil prices is not an aberration. It is not because of events in Libya, or Syria or Bahrain or Egypt. It results from the built-in pricing problems of the market itself.

This will guarantee higher oil product prices, supported by a number of the other elements we have been discussing over the past 15 months.

A Look Forward
As another presidential election cycle begins, you need to keep this in mind. Political rhetoric aside, the gasoline-pricing issue - and the cost of crude oil - is not a result of Democrats, Republicans, Independents, Vegetarians, Reformed Druids, or any other political party or movement.

This comes from the oil market itself.

We will continue to bounce from crisis to crisis until we recognize this fact - and begin the genuine, difficult, exasperating, long and incredibly expensive process of moving from a crude-based economy to a more balanced energy model.

[Editor's Note: In today's essay, Dr. Kent Moors said that America must ultimately move from a crude-based economy to a more balanced energy model.

On one front, at least, we're already making strides. 

Indeed, one little American company is pioneering power conversion solutions for the renewable energy markets. Its newest technology is nothing less than a breakthrough that will finally bring solar energy squarely into the power-generation mix. 

But here's the stunner: You can still get shares for less than $4.

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