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"Oil as the New Gold": CERA Comments on the New Fundamentals of Oil and Record High Prices

"The new fundamentals" - global financial dynamics and new cost structures - are driving the momentum that pushed oil prices to record highs around $110 a barrel, well ahead of what had been the previous inflation-adjusted record high of $103.59 set in April 1980, according to Cambridge Energy Research Associates (CERA), an IHS company.

"Oil has become the 'new gold' - a financial asset in which investors seek refuge as inflation rises and the dollar weakens," said Daniel Yergin, chairman of CERA and executive vice president of IHS. "The credit crisis has been fueling the flight to oil and other commodities, and that will last until the dollar strengthens or the recession becomes more pronounced."

"Shortages of equipment and personnel are dramatically raising the cost of developing an oil field," said James Burkhard, managing director, Global Oil Group at CERA, citing the latest IHS/CERA Capital Cost Index, which shows a doubling of oil field costs over the last three years.

"Adding to this pressure is increasingly heavy fiscal terms on oil investments in the form of higher taxes and greater state participation in oil projects. The net result is much higher oil prices are needed to support development of new oil supplies.

"These financial and cost structure dynamics are new in the sense that they were not strong forces in determining the oil price in the 1990s and even earlier this decade," he continued. "The 'old fundamentals' - the balance between demand and supply - still matter, but it is these new factors that are the driving force behind the record high."

"Today, the falling demand for dollars is just as important as the rising demand for oil in determining the oil price," said Yergin. "However, when looking back to 1980, today's high prices also have a 'back to the future' quality. Many similar elements that have contributed to the rise in price from $70 last summer to over $100 today were also in play in 1980: high inflation, a rush by financial markets to invest in commodities - gold's all-time high was in 1980 - and tension between the United States and Iran."

Following on the Iranian Revolution that toppled the ruling Shah of Iran, April 1980 saw: a failed U.S. attempt to rescue American hostages held in Iran; threats by Iran to choke off supplies from the Persian Gulf and to set the Gulf's waters ablaze with oil and a suspension of Iranian oil exports to Japan. Just a few months later, war broke out between Iran and Iraq. In financial markets, April 1980 saw surging inflation and gold prices that were triple the level of just two years earlier.

"Today's dynamics in the marketplace reveal oil's increasingly cosmopolitan nature," said Burkhard. "The price of oil reflects not just levels of demand and supply, but broader macroeconomic and geopolitical changes such as the growing influence of Asia, the Middle East, Russia and the Caspian countries at a time of economic downturn in the United States.

"Further weakening of the dollar, compounded by higher industry costs, could push the price of oil to new records, similar to the $120-plus level we identified in CERA's Breakpoint Scenario in 2006," said Burkhard.

"But the biggest offset in the other direction would be the spreading of the economic downturn beyond the United States, which would both weaken demand and strengthen the dollar against other currencies, reversing the upward surge in oil prices.

"There are different indexes and methods that can be used to adjust prices to inflation," Burkhard explained. "These methods can result in prices that are lower or higher than our $103.59 per barrel calculation.

However, we believe that using an annual average inflation rate - with 2008 estimates based on recent trends in the U.S. Consumer Price Index - provides the best basis for comparison between 1980 and 2008."

CERA's calculation of $103.59 is based on the April 1980 nominal average posted price of $39.50 per barrel for West Texas Intermediate. This is a monthly average price since, at the time, there was no crude oil futures market to provide a daily price.

Crude oil futures trading did not begin until 1983. Last November, CERA had used $99.04 as the 1980 "highpoint," but the surge of inflation since means that the $99.04 needs to be inflation-adjusted up to $103.59.

About the Author

Daniel Yergin, chairman of CERA, received the Pulitzer Prize for "The Prize: The Epic Quest for Oil, Money & Power" and the United States Energy Award for lifelong achievements in energy and the promotion of international understanding. Vist CERA.

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