Some signs of relief on gasoline prices

Some of the long-term factors that have pushed oil prices to record levels are starting to change.

In large part because gasoline prices are over $4 a gallon, demand for fuel in the US is falling for the first time in 17 years. China is raising prices for gasoline and diesel – a move that might ultimately lower demand. And, on Sunday, there were signs supply might increase as Saudi Arabia's oil minister indicated that the country would increase production through the end of the year if needed. Iraq is also set to sign contracts with foreign companies to hike production.

"It's all a step in the right direction," says Phil Flynn, an oil analyst and trader at Alaron Trading in Chicago. "These are certainly signs to the market that prices can't just continue to go up."

However, some of the shorter-term factors are becoming worse.

On Friday, the energy markets were digesting news of an attack on a Royal Dutch Shell oil platform in Nigeria that shut down over 200,000 barrels of oil per day in production. Then energy traders fretted over news of an Israeli military exercise involving 100 planes, with some speculating that the aim of the exercise was to send a message about Iran's nuclear ambitions.

And, it's not clear how badly the US corn crop, used to make ethanol, a gasoline additive, has been hurt by the flooding in the Midwest.

"These factors are keeping the price up for now," says Mike Fitzpatrick, vice president of energy risk management at MF Global, a commodities brokerage.

By the end of day Friday, the price of oil had closed at $134.62, down 24 cents for the week. Nationally, the price of gasoline is $4.07 a gallon, according to American Automobile Association, down 1 cent a gallon from the record high.

Short term tensions

The attack on the Royal Dutch Shell platform occurred last Thursday, about 75 miles offshore. Although Nigerian rebels had attacked oil rigs before, this is the furthest from shore they have ventured. "When the manager saw the attack, he immediately shut down production of the oil and natural gas," says Rainer Winzenried, a spokesman for Shell in The Hague, Netherlands.

As of Sunday, the Shell platform was still shut down. Mr. Winzenried says Shell has declared force majeure, a legal move that frees the company from its obligation to deliver oil. "It can only put upward pressure on the prices," says Mr. Fitzpatrick.

The energy markets were also roiled by a news story in The New York Times that Israel had mounted a military exercise involving 100 F-15s and F-16s. The article linked the exercise to Iran's nuclear ambitions. "What are the Israelis thinking?" asks Fitzpatrick. "It lights up the whole area."

Over the short run, the energy markets are also watching for updated corn crop estimates given the flooding in the Farm Belt. On the futures market, the new crop corn is up about 25 percent in the first half of June. "One of the uncertainties is the ethanol situation in the Midwest," says Tancred Lidderdale, an energy analyst at the Energy Information Administration in Washington.

"A number of plants are shut down, there has been a disruption of the distribution process, and the railroads are flooded," he says. "We typically have gotten imports from Brazil, and they can increase their exports but I'm not sure they will."

With gasoline prices on the rise for months, consumers are now starting to cut back. According to the EIA, in the first quarter of the year, demand for gasoline fell about 100,000 barrels per day, or about 1.3 percent of daily consumption. For the year, EIA expects consumption to drop 0.7 percent over 2007. "This would be the first year over year decline in consumption since 1991," says Mr. Lidderdale.

The lower gasoline consumption is probably due largely to less driving. According to Department of Transportation statistics released last week, from November through April, Americans drove 30 billion fewer miles than the same period the prior year. "That's the sharpest drop in recorded history, some 66 years of collecting data," says Doug Hecox, a spokesman for the Federal Highway Administration in Washington, adding that "the drop took place before the price hit $4 a gallon."

China's price hike

Initially, oil prices fell after China announced it was raising the price of gasoline by 17 percent and the price of diesel by 18 percent. Some analysts thought it would cut demand, which grew by 7 to 8 percent on an annual basis in the first quarter. But, in the last three months, demand growth has slowed to 3 percent, partly because of shortages, says Paul Ting, an energy analyst.

Now, he says Chinese refiners, although they are still losing money, might increase production somewhat. "So, we have conflicting forces, higher prices which might have some marginal impact on demand and more product available from the refiners," he says. "I think the end result will be an increase in demand, but not back to the 8 percent growth rate."

Slowing demand may be met by an increase in supply. On Sunday, Saudi oil minister Ali el-Naimi, at a special meeting of oil consumers in Jeddah, said production might increase over the current 9.7 million barrels of oil per day if the market needs extra supplies.

The kingdom had already committed to produce an extra 200,000 barrels a day starting in July on top of an additional 300,000 produced in May.

The extra Saudi production comes at a time when Iraq is also talking about adding to its capacity. Last week, the Iraqi government said its production was up to 2.5 million barrels per day, about where it was prior to the coalition invasion. On Sunday, officials also said it was awarding additional oil contracts to 41 foreign companies in the hope of boosting exports by another 500,000 barrels per day. It will be the first time the global energy companies will be back in Iraq since Saddam Hussein kicked them out in 1972.

Wire service material was used in this story.