Zia Mian, Contributor

The 148th Meeting of the Conference of Organisation of Petroleum Exporting Countries (OPEC) ended March 5, in Vienna. My friend and former colleague at the World Bank, Dr Chakib Khelil, (the minister of Energy and Mines - Algeria), is the current president of OPEC. He announced to the waiting world that OPEC members have agreed not to boost the production from the current level of 29.67 million barrels per day, excluding production from Iraq.

Contracts shot up

On March 6, the New York Mercantile Exchange (NYMEX) reacted to this news and the price of West Texas Intermediate (WTI) for April contracts shot up to a new high of US$105.97 per barrel. This is the first time that the price of oil has broken the real-term peak reached in 1980.

TheUnited States administration and the International Energy Agency (IEA) have both criticised OPEC for its refusal to increase production. President Bush called the OPEC direction "a mistake".

Since the start of 2007, the price of crude oil on the NYMEX has more than doubled. In 2006, Jamaica spent over US$1.7 billion on oil imports. This accounted for more than 87 per cent of Jamaica's export earnings. For 2007, the oil import bill is estimated to be about US$2 billion, which is likely to require over 95 per cent of Jamaica's annual export earnings.

OPEC defends its decision not to increase the production on the grounds that there are abundant supplies in the market and any increase in production would not help bring the prices down. Khelil cited an example that OPEC's decision to increase production during Septem-ber last year was actually followed by an increase in the prices. It appears that the supply-demand fundamentals are no longer operative. The question is: Has the traditional economic theory fallen apart?

While it is true that there are adequate supplies in the market, the oil prices continue to soar, defying the price, equilibrium theory. Some of the factors that are causing volati-lity are rooted in the distortions of the US economy and have resulted from the financial crisis and ensuing economic recession. Khelil refers to the US factor as the "mismanagement of the US economy".

Let me briefly review the over-riding factors that are driving the current oil-price volatility.

First and foremost are the global credit crunch and the weakening of the US dollar against all major currencies. Following the subprime fiasco in the US, there were significant outflows from pension and hedge funds into widening speculative commodity trading (including oil).

More than US$175 billion was invested in speculative commodity trading and, as a result, prices of most commodities increased significantly. In July last year, speculators held about 127 million barrels of oil contracts.

Once under pressure for cash, they sold about 100 million barrels of oil contracts in August. No physical volumes of oil were traded.

As a consequence, the price of oil dropped to below US$60 per barrel. At present, the speculators have pushed their stake in the price to about US$27 per barrel (speculative premium).

In the US, the refining capacity is stretched. With emphasis on renewables and biofuels, the refiners have delayed their investment decisions to modernise or upgrade the refineries. As the transport sector is the single largest consumer of petroleum in the US, in 2006, more than 44 per cent of the demand for petroleum was for gasolene alone.

Any real or perceived imbalance in the supply of and demand for gasolene normally sends shock waves to the oil prices. A poorly thought-out policy that promotes biofuels would not only have a negative impact on food prices, but would also hamper refining capacity and necessary investments.

It would also cause global shortage of food grains. With more expensive food grains, the price of chicken and beef would also go up. An inflationary pressure is imminent.

Political instability

Historically, petroleum price volatility has been caused by political instability in oil-producing countries. At present, there are four such political developments that continue to impact oil-supply security concerns. First, the tension between Iran and the West which has arisen out of Iran's continued uranium-enrichment programme.

Second, insecurity in the Niger Delta which has been affecting oil prices since 2006.

The third reason is the political instability in Iraq - with the world's second-largest proved reserves (115 billion barrels) - which continues to have a negative impact on efforts to normalise its productive capacity.

Finally, Venezuela has taken a position and asked Exxon/Mobil to enter a joint-venture arrangement with the government by the end of this year - a position supported by OPEC. And the tension between Venezuela, Colombia and Ecuador has contributed to the recent oil-price increases. These non-fundamentals add to the supply security-risk premium which I estimate to be around US$20-25 per barrel. It is, therefore, more than the basic supply-demand fundamentals that are the main causes of the current price volatility.

Zia Mian, a retired senior World Bank official, is an international consultant on information technology and energy. He may be reached at mian_zia@hotmail.com.