The relentless rise of oil prices in recent years has been accom-panied by a widening gulf between producers and consumers over the cause of rising prices. Consumers say increasing prices are caused by a lack of oil supply. Opec, the cartel of countries responsible for about 40 per cent of this supply, needs only to open the taps and the market will once more be in balance, they argue.

For its part, Opec insists the market is not undersupplied, and says there is a gap between oil prices and the fundamentals of the supply/demand balance. The disparity is caused by market speculation, it argues, with prices being pushed ever higher by market makers buying up oil futures to make a profit on the rising market.

The stakes are now so high that on 22 June, the world’s major producers and consumers, along with leading financial institutions, met in Jeddah to try to understand the reasons for the exponential rise in oil prices.

That the meeting was held in Jeddah is fitting because Saudi Arabia is at the centre of the debate. The kingdom sits on the world’s largest oil reserves and is the biggest global oil exporter. It is also the only major global oil producer with the ability to significantly increase production, with spare capacity of about 1.3 million barrels a day (b/d). When consumers demand that Opec increases production, they are really asking Riyadh.

Market control

“Given that Saudi Arabia is the main holder of spare capacity, it has a certain degree of market control,” says one senior European oil markets analyst. “But at the same time, when everyone else in Opec is running at full capacity, Saudi Arabia is the only one that can raise output, which puts it in a difficult position.”

In the past few weeks, Western leaders have increased the pressure on Riyadh to bring some of this capacity on stream to relieve the pressure on prices. “It is a scandal that 40 per cent of the [world’s] oil is controlled by Opec, that their decisions can restrict the supply of oil to the rest of the world, and that at a time when oil is desperately needed, Opec can withhold supply from the market,” said UK Prime Minister Gordon Brown on 19 May.

Two days earlier, US President George Bush dismissed as insufficient Riyadh’s pledge to increase production by 3.3 per cent to 9.45 million b/d in June, pushing the kingdom to encourage its Opec colleagues to further increase production. On 13 June, the G8 (the world’s eight leading industrialised nations) also called for an urgent increase in oil production. They acknowledged that geopolitics and financial markets play a role in prices, but said the increase was “fundamentally” driven by rising world oil demand and supply constraints.

That the West should turn to Saudi Arabia to alleviate high oil prices is no surprise. Western thinking is still shaped by the scars of 1973, when Opec’s oil producers withheld supply to the world’s major consumers, increasing prices and triggering a recession. When these same consumers see the oil market spiralling out of control once more, they are liable to return to the root of previous crises to seek a solution.

Limiting supply

“If it is speculation that is driving up prices, then we should see some imbalances in the market,” says Lawrence Eagles, head of the oil industry and markets division at the International Energy Agency, which represents the interests of 27 consuming countries.

“But the second-quarter crude oil stock build looks considerably lower than normal, which suggests crude oil supplies are quite tight. Oil refining margins are also tight, which suggests there is either weak demand for refined products or not enough crude supply.”

Given that there is no shortage of demand for refined products, the argument goes, tight refining margins must be the result of an undersupplied market for crude.

But crude stock statistics can be used to support either side of the argument. “Stocks are at the higher end of the range for the past five years,” says Paul Stevens, senior research fellow at the Royal Institute of International Affairs in London. “There are blips in the US stock data, but the information is extremely unreliable.”

Much of the West’s criticism of Saudi Arabia and its Opec counterparts is little more than political hot air. It is natural that the leaders of countries facing the twin effects of a global economic downturn and rapidly rising inflation should seek to find a scapegoat. And with rising prices at the petrol pumps – one of the most sensitive issues for consumers in the developed world – pointing the finger at the world’s largest oil producer is a convenient way for their political masters to divert the blame.

Riyadh, still largely non-plussed by the barrage of criticism it is facing from overseas, has nevertheless relented in the face of the West’s demands. In early June, it signalled that from July it would increase oil production by 200,000 b/d, in addition to the 300,000-b/d incremental increase already promised from June onwards.

“Saudi Arabia has always been a moderator,” says John Sfakianakis, chief economist at Saudi bank Sabb. “When the question of prices was raised by the G8, it wanted to show it was willing to address the issue of supply, even though it still believes this is not the cause of the oil price hike. It gets little credit from consumer nations for being the only country willing to invest money in having extra capacity.”

In maintaining a cushion through which it can help to moderate world oil prices, Saudi Arabia is not simply being altruistic. In the past, the ability to exert control over prices has given the kingdom an important strategic advantage. Now, rising oil prices are threatening to destroy the very demand on which the kingdom relies by forcing developed nations to reduce oil consumption and making alter-native sources of energy supply increasingly viable.

Destroying demand

“There is a fine balance between demand and demand destruction,” says Sfakianakis. “Every-one is talking about security of supply, but no one talks about security of demand. Saudi Arabia would be happy to have a fixed price for a few years rather than face insecurity. What if the world discovers fusion in the size of a combustible engine? What would happen to demand security then?”

Besides a desire to show world markets that it is trying to do the right thing, it was concern over rising prices that pushed Saudi Arabia to convene the 22 June meeting of global oil players. Even when oil prices reached $100 a barrel, Opec, fearful of demand destruction, said it did not like to see them so high. Despite consumers’ concerns that there is not enough crude supply in the market, in June Opec cut its global oil demand forecast for 2008 for the fifth consecutive month, to 86.88 million b/d from 86.95 million b/d.

“Saudi [Arabia] is genuinely bemused as to why prices are so high,” says the analyst.

As Western leaders are quick to point out, basic market economics suggest that if you want to reduce prices, all you need to do is increase supply. Why then, with prices close to $140 a barrel, has Riyadh been reluctant to do so?

The answer is that there is a growing gulf between the physical oil market and the paper oil market. The physical market is determined by the daily balance between supply and demand for barrels of oil, while the paper oil market is governed by how much traders are willing to pay for the option to buy oil on the futures market. Although the two are linked, they are not necessarily based on the same fundamentals. “Money managers don’t need to understand oil,” says Stevens. “They only need to understand other money managers.”

The 13 per cent increase in oil prices between 5 and 6 June was the highest ever rise in a 48-hour period. On 6 June alone, prices increased by $10.75. But the hike had little to do with the physical oil market. While there were belligerent words from Israel about the prospect of war with Iran, they did not alter the geopolitical landscape enough to justify such a huge increase in prices.

The increase was instead driven by an announcement that US unemployment had risen to 5.5 per cent. In the physical oil market, such news would dampen prices – rising unemployment being a good indicator of an economic downturn that would depress oil demand. But in the paper market, rising US unemployment means a weakening dollar, which encourages traders to buy oil to balance their portfolios. “It is like Pavlov’s dogs,” says Stevens. “Only instead of ringing bells and dogs eating food, it is the dollar falling and people buying oil futures.”

The disconnect between the physical market and the paper market was also highlighted by the negligible impact of Saudi Arabia’s promised production hikes. Within 24 hours of news emerging that it was likely to increase production in July, oil prices hit a new record, peaking at $139.89 on 16 June. Again, news of a 150,000-b/d outage in Norway might explain why prices did not fall significantly, but given that this was outweighed by the prospective Saudi production hike, it does not account for the record highs.

“There is absolutely no logic to the high oil price,” says Stevens. “The whole thing bears very little relationship to the wet [physical] barrel market. A year ago, the price was $80 a barrel; now it is more than $130 a barrel. What has changed? Nothing.”

An admission that there is a disconnect between oil prices and the fundamentals of the market is not to say that the world does not face supply issues in the longer term. Supply growth from non-Opec countries is very weak – if not negative – and rising demand from developing countries will put pressure on the market in the years ahead.

“We think that non-Opec oil supply will actually fall this year,” says Kevin Norrish, head of commodities research at investment bank Barclays Capital. “Russian production is falling year on year and non-OECD [Organisation for Economic Co-operation & Development – a grouping of the world’s most developed countries] demand for oil is growing much more rapidly than the OECD demand is contracting.”

The complication of market dynamics caused by oil investors taking an increasing role, and the implications of a long-term oil supply shortage, mean that Saudi Arabia is in a weaker position to manipulate oil prices than ever before.

“Adding extra oil to today’s production does not affect the long-term trend of non-Opec supply growth falling,” says Norrish. “Increased production from Saudi Arabia goes some way to filling the short-term gap, but not enough to relieve the continuing market situation.”

Riyadh’s strategy continues to be that of a swing producer, with plans to secure more than 12.5 million b/d by early 2009.

But with the growth of non-OECD demand and the poor performance of non-Opec supply set to continue in the years ahead, even this might not be enough to satisfy the market.

“The more spare capacity you use, the less flexibility you have to deal with an outage, so this too can put pressure on prices,” says Norrish. “The bottom line is that Opec does not have a lot of spare capacity, and that is more important than how much it is producing.”

Whether the disparity between oil prices and the supply/demand balance is a reflection of the gloomy long-term outlook for the market, or whether it is down to the self-perpetuating cycle of oil futures traders buying on an upward curve, is difficult to assess. It is combination of the two.

But whatever the cause of the oil price escalation, Riyadh’s ability to do something about it has been permanently weakened.