Traders cited the cratering dollar, combined with international tensions stoked by rumors that Israel might be planning an attack on Iran.

Kevin Kerr, editor of Global Resources Trader said that “fear by far is the biggest driver right now … Shorts were certain earlier in the week that oil would freefall and with [Thursday’s] rally and then [yesterday’s] event, even hardened traders are left shaking their heads.”

That flame of fear was fanned by Israel’s Transport Minister Shaul Mofaz, a close adviser to Prime Minister Ehud Olmert, who was quoted in a local newspaper as saying that if Iran continues with its program for developing nuclear weapons, an Israeli attack on that country’s nuclear sites is “unavoidable.”

Morgan Stanley analysts wrote that they expect to see a short-term spike in oil prices, with crude-oil shipping patterns suggesting that prices for West Texas Intermediate crude will reach $150 a barrel by July 4.

“Distribution patterns of crude oil out of the Middle East are mimicking those of last year as we exited 3Q07, when we predicted an oil price spike into year-end based on our projections of sharp inventory draws in the Atlantic basin,” the analysts wrote. “That same pattern is now again upon us, and we are making an identical call, only this time we are starting from a much tighter Atlantic Basin inventory backdrop.”

Source: Meanwhile, Crude Heads for the Moon

Two things are obvious here. One, American thinks they’ve raised prices as much as they can without causing customers to bail out on them in droves. Two, they’re either clueless or clearly out of options.

The airline industry is long overdue for some serious consolidation. And it’s finally beginning to happen.

In April, Delta and Northwest decided to hook up. And now talks are heating up between United Airlines and Continental.

But despite all the time airlines have spent in and out of bankruptcy, it’s still the same old talk about cutting costs, cutting corners and raising prices when the market allows.

For example, here’s the brilliant strategy that Delta’s president, Edward Bastian, articulated in response to high jet fuel prices: “We have moved quickly to mitigate the short-term impact of higher fuel prices by further reducing domestic capacity and taking a disciplined approach to costs and cash flow.”

YAWN.

It doesn’t take a genius to figure out how airlines are doing. All you have to do is follow crude prices. The airline stocks move more or less in the opposite direction.

The U.S. Oil Fund (USO), the dark blue line in the chart, tracks the spot price of West Texas Intermediate (WTI) light, sweet crude oil. When it was going down in the second half of 2006, airline shares were going up. With oil taking off in 2008, the shares of airlines have plunged.

The problems plaguing U.S. airlines should be well-known by now: unionized pay scales, legacy health and pension obligations, and a bloated and demoralized work force.

In many ways, the airlines have been their own worst enemy. They’ve cut back and cut back on services and perks, that they’ve essentially commoditized themselves.

How do you distinguish one airline from the other? One serves crackers and the other serves peanuts? That’s sure to cultivate customer loyalty.

They have only one trick in their bag of goodies which saves them from being completely commoditized. And that’s their frequent flyer plans. But you know what? It feels more like blackmail than a perk.

I’ve stacked up a couple hundred thousand frequent flyer miles with Northwest. But I don’t care anymore. I hardly fly Northwest. Their service is mediocre and their tickets are expensive. I go mostly with the newer low-cost carriers.

Have I made my case? There are plenty of reasons to hate airlines. As a passenger and a consumer, I’m not going to make you fly on any airline that is pissing you off.

But, as an investor, I’d like you to reconsider your feelings about the airline industry…

First of all, in terms of affordability, air travel has flown in the opposite direction of things like higher education, houses, and designer jeans.

When I first flew to England back in 1973 to attend Lancaster University, the two-way flight cost me around $525. When I flew Rachie – my daughter – to England last year to attend Norwich University, the round trip cost $600.

That’s nothing short of astounding. Taking into account inflation, the $525 price would have more than quadrupled. In real money terms, that ticket now would cost $2,444. It may not feel like it, but flying is a ridiculous bargain.

People have to fly. And, globally, it’s inevitable that they’ll be flying in greater numbers. Higher prices may slow this trend, but it won’t reverse it.

Flying is already taking off in Asia. For example, China’s domestic airline industry is just a fifth of the size of the U.S.’ domestic market, but it’s growing much faster. In 20 years time, it’ll be about half the size of the U.S. market.

Earlier this week, NYMEX crude oil futures, in un-lady like fashion, bolted to an intra-day high of US$127.27. It capped an exuberant dash which saw oil gain over 8% in six trading days, 30% since the beginning of the year, and 100% in the last twelve months. It’s just the sort of thing you’d expect from a ten-year old.

Here is an astonishing fact: on December 10th, 1998 the spot price for a barrel of West Texas Intermediate crude was exactly ten U.S. dollars and ninety eight U.S. cents. Nearly ten years and one thousand and sixty two percent later, it is time to ask some impolite questions about oil.

Impolite questions are not always obvious questions, though. The obvious question is to ask how high oil can go. Arjun Mutri and his team at Goldman Sachs have told us a disruption in supply could send oil to another “super spike” over US$200. Two years ago, the “super spike” was supposed top out at $100. Maybe it will be US$500 two years from now.

It is easy to keep raising the figure, but is probably more useful to ask a different question. The important investment question is not how high oil can go from here. The impolite but important investment question is where future global oil production will come from at all.

The answer, according to a new report from UBS, lies with just eight oil companies, one of which investors can’t even buy. Below, I’ll look at where future production may come from, who stands to profit the most, what investors can do now, and three “Black Swan” possibilities for the oil market that no one has prepared for.

Why Are Oil Prices So High?

An obvious question on the lips of anyone who buys petrol is, “Why are oil prices so high?” Consumers trained in the ways of the free market—and used to cheap clothes and electronics made in China—are right to ask the question.

In a fully-functioning free market, rising demand tends to attract rising supply. The reason?
Profit.

When a market is imbalanced and demand exceeds supply, prices rise. At that point, opportunistic new producers tend to rush in and grab some of the profits by brining on new supply. Prices fall and, for awhile anyway, equilibrium is restored.

That’s how it works in textbooks. That is not how it’s been working in the real world. According to the International Energy Agency, world oil demand has increased in each of the last three years, from 84.9 million barrels per day in 2006, to 86mbbl/day in 2007, to this year’s rate of 87.2mbbl/day. The IEA’s most recent forecast calls for global demand of 87.8mbpd for the rest of this year.

In response to this increase in global demand, OPEC oil production promptly declined by 265kbpd in February (the latest period for which official figures are available) to around 32mpbd. Not exactly helpful. And latest survey from Platts predicts a March decline in production of 347kbpd from the February figure. This brings average OPEC production below 30mbpd for the month.

This past weekend, U.S. President George Bush travelled to the Kingdom of Saudi Arabia, politely requesting the Saudis increase oil production to bring down gas prices in America. The Saudis demurred, and told the President oil production was more than sufficient to meet global demand.

OPEC blames the oil price on the weak U.S. dollar, but admits prices could go higher still. OPEC President Chakib Khelil explained the situation to journalists in late May, saying:

The prices are high due to the fact of the recession in the United States and the economic crisis which has touched several countries, a situation which has an effect on the devaluation of the dollar, and therefore each time the dollar falls one percent, the price of the barrel rises by $4, and of course vice versa.

In other words, OPEC blames the oil price on the sliding U.S. dollar and not inadequate supply. Khelil added that, “If this (the dollar) strengthens by 10 percent, it is probable that (oil) prices will fall by 40 percent.” At today’s prices, that would put a barrel of crude at US$76.

Froth vs. Fundamentals

If you can say with assurance why oil prices are US$127, you are more assured than most. OPEC believes oil strength is really just U.S. dollar weakness. A stronger dollar means lower oil prices, and probably lower commodity prices in general. There are other theories that seek to explain the high oil price, including a “fear premium,” oil as an inflation hedge, and pure speculation by professional traders.

But there are three other possibilities to consider. Exploring them gives us a clue about where oil prices are headed and where future production might come from. These possibilities are:

1. OPEC won’t increase production because it doesn’t want to
2. OPEC can’t increase production
3. Non-OPEC countries cannot increase production enough to bring prices down

It is impossible to answer the first question. Oil producers, from OPEC to large multi-nationals, plan with long time horizons. They view oil markets as cyclical and do not base capital expenditure plans on pie-in-the-sky price forecasts. They are reluctant to recognise and respond to what your editor (among others) believes is a structural revaluation in global energy prices (not a cyclical bubble).

But this institutional skepticism about how long high oil prices can last does not account for the slump in this year’s production. OPEC’s production has fallen this year because of continued disruptions in Nigeria (see table below). Rebels in the Niger River Delta have reminded us all of how vulnerable the global energy system is to systematic sabotage. But excluding Nigeria, the rest of OPEC is running at near capacity.

Goldman Sachs raised its forecast yesterday for the average price of West Texas Intermediate crude in the second half of 2008 to $141 a barrel from $107 a barrel. Long-term oil prices will need to continue to rise to bring trend oil demand growth in line with trend supply growth, which stands at around 1% a year, Goldman said.

“We believe that the market is not defying fundamentals but rather experiencing a structural repricing much like it did in 2004, searching for a new equilibrium against an uncertain long-term supply environment,” Goldman wrote.

Source: Oil Blasts to Nearly $128 Before Easing