By Greg Peel

From the beginning of 2007 to the GFC in 2008, the US dollar index fell 17.5% from 85 to 72. In the same time frame, West Texas crude oil rose 195% from US$50/bbl to a peak at US$147/bbl.

From the stock market low in 2009 to now, the US dollar has fallen 15% from 88 to 75 and oil has rallied 215% from US$35 to US$110. While the latest oil rally has not seen as much of a fall in the dollar as a driver as the earlier oil rally, the two periods are quite similar. Except for one point.

The US dollar index was at 75 at the beginning of 2010. It has been all the way up to 87 and back to 75 again, but in the same time frame the oil price has barely stumbled. From the beginning of 2010 to now, oil has risen 57% from US$70 to US$110 and the US dollar has gone nowhere. So whatever has been driving the rally in the price of oil lately, it is not the US dollar.

What is driving the price of oil, of course, is expectations of underlying demand growth from China and other emerging markets. The case was the same in 2008 but back then the world was erroneously assuming China would be immune from the GFC, which it wasn't. But from a Chinese perspective, the GFC was just a troublesome blip. Basically we're back in 2008 again, and this time expectations of Chinese demand growth are not erroneous.

In 2008 the world's oil producers, from OPEC to US “Big Oil”, were crying “speculation!”. There is little doubt that back then speculators were very infuential in oil's price behaviour, reflecting a greater access to direct commodity investment than ever before through commodity funds, ETFs and so forth. OPEC, for one, was loathe to increase production at the time to curb the oil price because that would only mean pandering to the evil speculators. As it was, they didn't have to wait to find out, but now we're back in the same boat and OPEC and “Big Oil” are crying “speculation!” once more.

There is little doubt that the most recent spike in the oil price – and let's now focus on the more relevant Brent crude price today at US$122 – has a lot to do with MENA unrest. Realistically from the first protests in Tunisia, through the fall of Mubarak, to the civil war in Libya, Brent oil jumped from around US$80 to around US$110 as the market applied a risk premium – that risk being a possible supply shock.

As a result, global stock markets corrected by about 7%. Given the situation has really become no better but no worse since, and given there has been no net disruption to global supply as OPEC members have made up the short-fall, stock markets have returned to where they fell from (and of course the Japan story has been has seen a sell-off and rebound effect in between as well). Yet the Brent oil price, which did a lot of “work” in the US$110-115 range, has now broken up and sailed through US$120. Not only has there not been a correction in oil as well, oil has surged ever higher.

Is this just speculation? If so, what has changed?

Nothing has really changed, and the Chinese demand growth story remains intact. Barclays Capital notes with interest that this most recent break-up in the oil price has not been met with any form of intervention, either from producers (eg OPEC increasing quotas) or from governments (eg the US releasing strategic reserves as it did in 2008). It would seem, Barclays suggests, that the powers that be are merely “waving Brent through to US$130”.

A gallon of unleaded gasoline at the pump in the US is currently around US$3.68, Barclays notes. With the summer driving season coming up, the analysts suggest that US$4.00 might prompt at least some small release of strategic reserves. The irony here is that inventories at Cushing Oklahoma, the delivery point for West Texas Intermediate, are at record levels and the cost of remaining storage is at a stiff premium. That's why WTI trades at such a discount to Brent. One might be forgiven for suggesting the reason why America still sees WTI as “the oil price” is because of parochial foolishness, but then a more relevant US oil price would be that of Louisiana Light (oil from the Gulf of Mexico) which is trading in a tight range to Brent. So all we can conclude is that it's not a case of parochial foolishness – there's nothing parochial about it.

One day Wall Street will wake up, but in the meantime there is a very good reason why OPEC has not increased its production quotas. Normally OPEC would increase production at levels well above US$100 because here we reach “demand destruction” territory – levels of price which not only cause consumers to use less oil but also spark a shift to other energy sources such as LNG or green fuels. One day that shift will be permanent, and OPEC oil sheiks will be back to being nomadic goat herders.

OPEC would like to increase production, but then individually it already has. The UAE, Kuwait and particularly Saudi Arabia have been exploiting spare production capacity in order to make up for the shortfall of lost Libyan production. Iran has indicated it is happy for oil to go to US$150, Barclays notes, given Iran likes to be seen to be giving the US, and Western oil speculators, the finger. But then Iran doesn't have any spare production capacity. Anyone who does is currently using it.

In other words, there's very little OPEC can do about oil at or above US$120 at the moment anyway. If peace was declared in Libya and full oil production restored, then perhaps we could see a pullback. But even if some sort of truce eventuates, it might be a long time before Western oil companies go back into MENA and risk it all again.

This week ANZ's commodity analysts raised their oil price forecasts. They have moved their end-2011 price expectation for Brent from US$100 to US$128. ANZ has simply joined the queue of analysts, brokers and economists updating oil price forecasts recently, including long term price forecasts. You do not raise your long term forecasts if you think it's all just a speculative bubble that will shortly burst.

Indeed, ANZ suggests that oil was previously undervalued compared to other commodities and all it's done recently is played catch-up. And the geopolitical risk premium is here to stay, the analysts declare, at least until the end of the year. “We view the shift in the oil price floor to US$120 for Brent as muted,” they say, “and perhaps a better representation of improving demand fundamentals and tightening global balances”.

Let's recall 2008 again. Back then, the world thought the developed economies were toast but that the emerging economies would go from strength to strength. In 2011, the world still believes the emerging economies will go from strength to strength and the developed economies are getting back on their feet, with the US apparently leading the charge. And back then, there was no fear of a MENA supply shock.

Yet the oil price is still to reach 2008 levels.

There still could be, and no doubt will be, the odd snap pullback and speculative panic sell-off in between. But it's looking more an more like high oil prices are here to stay.

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