The Oil Market's Weather Obsession

The drop in oil prices has been attributed to the unseasonably warm temperatures. But that isn't the whole story

by Moira Herbst

Oil prices, after soaring last year, are falling fast in 2007. On Jan. 9, oil dipped below $53 a barrel on the New York Mercantile Exchange before settling at $55.64. Crude prices have plummeted about 30% from their peak last July, including a tumble of nearly 9% already this year.

What's causing the steep decline? One of the most commonly cited reasons is the balmy weather. Spring-like temperatures in the northeastern U.S. and Europe are supposed to be playing a key part in oil prices' drop to an 18-month low.

But there's a puzzling question at the heart of this argument: Why would the weather have that much of an effect? Warm weather does weaken demand for energy to heat homes and businesses. But only a tiny fraction of the oil consumed each day is ultimately used for heating. In the U.S., the figure is only about 7%. Some experts believe that trading oil based on the temperature outside is nothing more than mercury misdirection.

Weather Doubts

"People have attributed to the weather a much greater impact than it actually has," says Jeff Rubin, chief economist for CIBC World Markets (CM). The financial services firm put out a report on Jan. 9, as the market was sliding, titled "Are Energy Markets Paying Too Much Attention to the Weather?"

In markets as in many other things, however, perception is reality. The price of oil is determined at any given time by a multitude of factors, from the political situation in Venezuela, to the economic growth in China, to weather in the U.S. If the expectations for one of those factors changes, traders push prices up or down based on their changed perceptions, often by a degree well beyond the fundamentals.

"Oil prices are determined at the margin, so fluctuations in the margin drive fluctuations in prices," says Craig Pirrong, professor of finance and energy markets at the University of Houston's Bauer College of Business. "Every little movement in demand can have a major impact on price, and that's what we're seeing with the weather now."

Price Adjustments

Pirrong says that with an unexpected change, markets usually respond by adjusting quantity or adjusting price. In the energy market, adjusting supply is difficult in the short run, so all the burden of the shock falls on the price. "As winter approaches, everyone in the industry knows the demand for heating oil will go up," says Doug MacIntyre, senior oil analyst for the Energy Information Administration of the Energy Dept. "If demand isn't there as you thought, prices go down."

The price declines have taken their toll on major oil companies. The stocks of Exxon Mobil (XOM), Chevron (CVX), ConocoPhillips (COP), and BP (BP) have all taken a hit this year.

Rubin, of CIBC World Markets, points out that the futures markets may be exaggerating the price movements for oil. Futures contracts are agreements to buy or sell oil or other products in the future, at a price agreed on today. A small price decline now can lead traders to expect greater decreases in the months ahead, dragging down futures contract prices. "Sometimes perception becomes reality—especially in the futures market," says Rubin. "If people think warm weather will have a huge impact on reducing oil demand, they'll start selling oil, leading to the appearance that it does" (see BusinessWeek.com, 1/8/07, "Oil: Next Stop, $45?").

"Excessive Speculation"

CIBC's report on energy markets and the weather says that "a fixation on the weather is masking some key positives for oil that could see prices set new records in coming quarters." The report says that near double-digit demand for oil from countries such as China, and "rampant energy nationalism" tightening production in countries like Russia and Venezuela, will likely buoy oil prices in the future.

Fadel Gheit, senior energy analyst for Oppenheimer & Co. (OPY), offers a sharper-toned rebuttal to oil market bears. "You can't reason with the market," he says. He argues that oil price volatility occurs in part because of "excessive speculation" by hedge funds and major financial institutions. He doesn't expect that to change, but he doesn't think it's rational either. "The volatility will continue; that's how traders make money," says Gheit. "The rationale [for a stable price] may be simple, but what takes place is a different story."

With the dramatic price movements of the past two years, it's clearly hard to predict what will set off the price of oil next—and in what direction. "So many different factors influence oil prices," says MacIntyre. "You never know what the main factor will be at any one time—a hurricane, a supply disruption. The unexpected is the best place to look for what's impacting oil prices the most."

Herbst is a reporter for BusinessWeek.com in New York.