Thursday 6th March, 2008


Oil prices explode

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A decade ago analysts would have never forecast that the price of oil would reach US$103 a barrel. On February 29, light, sweet crude for April delivery jumped to a new trading record of $103.05 on the New York Mercantile Exchange. The cause of the rise of oil prices to these historic highs has been a combination of several factors such as, supply and demand, speculation, economic conditions and hedging. These factors will continue to play a pivotal role in the price of crude oil and will determine if the price will continue to rise, hold steady or decline.

The high price at which oil is trading may be positive for the local economy, since oil which is exported would generate a higher revenue stream. The higher revenue stream should generate higher growth if it finds its way into the local economy. However, this may not all translate into positives since there is also the risk of higher inflation levels.

Investors looking to invest in companies which are directly involved in the oil industry should examine such investments carefully, since the high oil prices may not be reflected in the price of the stocks of such companies. The S&P 500 Energy Index which is comprised of companies such as Schlumberger Ltd, Chevron Corp and Sunoco Inc generated a loss of 2.05 per cent year-to-date as of February 28, while Dated Brent Crude Oil appreciated by 6.75 per cent within the same period.

For those who may still insist in investing in these companies, access to the US equity market for the local investor is still limited to a few financial houses. On the local stock market there are no companies which are listed on the exchange which are directly involved in the oil industry. However, there are mutual funds such as the UTC Energy Fund and FCB First Energy Fund which are invested in the Energy sector. But will the price of oil continue to rise?

The law of supply and demand is the simplest economic reason behind the increase in the price of oil. When the demand is higher than supply the price of oil goes up, however, when supply is higher the price of oil is supposed to drop as well. It has been noted that historically the price of oil as well as demand and supply have been increasing.

As of January 31, the total product demand for crude oil was 86.2 million barrels a day while the total supply stood at 87 million barrels a day. This represents an increase in demand from 74.5 million barrels a day and a supply of 75.7 million barrels a day as of January 31, 1998, by approximately 15 per cent. The price of oil as represented by dated Brent Oil, however, increased significantly moving from US$15.57 to US$92.56 within the same period which meant an increase of 498 per cent.

In response to the high oil prices the Japanese government on Friday urged the Organisation of Petroleum Exporting Countries (Opec) to increase output to help ease record prices. Opec, on the other hand, begged to differ. In its latest report from the meeting held on February 1, Opec stated that, “In view of the current situation, coupled with the projected economic slow-down, the conference agreed that current Opec production is sufficient to meet expected demand for the first quarter of the year.

At the same time, however, the conference noted that the significant uncertainties associated with the projected downturn in the global economy called for vigilant attention to their impact on key market fundamentals until its next meeting on March 5. The conference reiterated the organisation’s determination to take every measure deemed necessary to keep the market stable.”

In fact, Opec may be looking for a reason to cut production, if not leave it unchanged, as supported by comments by Opec president Chakib Khelil. Khelil noted that oil inventories were growing, and that the recent rally in oil prices has been driven by the US dollar’s weakness and speculative trades amid geopolitical risks. See Figure 2

The US economy has been struggling to avoid a recession within recent months. This has led to speculation that the US, which is one of the largest users of oil, will experience a decline in the demand for oil causing a downward pressure on the price of oil. Growth stemming from a growing manufacturing industry and a growing middle class in India, China and Russia has sparked an increased in demand for crude oil in the last two years.

Currently non-members of the Organisation for Economic Co-operation and Development (OECD) account for approximately 43 per cent of the world’s demand, of which China accounts for 8.6 per cent of this demand. (See Table 1). However, a global slowdown may curb large increases in demand for oil.

Recently, the US Federal Reserve has continued to cut interest rates in an effort to stimulate growth but this has also resulted in the weakening of the US dollar. With the depreciation of the US dollar the value of a barrel of oil has fallen in relation to other currencies. This has caused the price of crude oil to be propped up since it has become a relative bargain for buyers overseas.

According to the Associated Press other commodities such as gold, which is seen as a hedge against inflation, has also reached record highs for this year. Gold is up 12 per cent for the year, aluminum is up 18 per cent and wheat is up 34 per cent. There continues to be an influx of investments into the asset space. New players, including sovereign wealth funds from China and the Middle East, have entered the market.

Other investors may be buying commodities as a hedge against inflation, catastrophe, or a weak US dollar. It is the view of some analysts that speculation of an impeding cut in interest rates will cause investors to buy oil futures as well as other commodities causing the prices of these commodities to move further upwards in the short term.

The rising oil price has had its effects on several countries especially those such as the US which has become so dependent on this commodity. The price of gas at the fuel pump in the US has risen to historic highs. For many people this translates into increased costs for products due to the increase of transportation costs and input materials. In a country which is struggling with a drop in growth and rising inflation, this cost spells disaster in the form of stagflation.

In simple terms, stagflation is an economic condition of both continuing inflation and stagnant business activity. For persons invested in the equity markets this could translate into lower revenues for business which would lead to lower earnings per share (EPS) and hence decline in stock prices.

The Federal Reserve chairman Ben Bernanke has realised that this may be of concern to investors and reassured them that the American economy is not immediately threatened with stagflation.

In the short term there is the possibility that the price of oil may undergo some corrections. This is based on the fundamental data of record crude production and faster than average US crude and gasoline stock builds according to data supplied by the International Energy Agency (IEA) and Energy Information Administration (EIA).

Some analysts believe that even if there are further interest rate cuts, additional dollar weakness and more investment buying which will anchor oil to higher prices, it can’t last forever. This is supported by other analysts who have warned of a price bubble forming in the crude futures market as investors continue to ignore the fundamentals. As with all bubbles, when it bursts there is the chance of a sharp correction. However, if Opec does cut supply, oil prices may remain at this level for a while.

Global oil balances point

to weakness in Q2 and Q4

In the long term the outlook for oil points to a decline in the price of oil in the future according to estimates provided by Bloomberg. There is the belief that the market is softening in the short run, seasonally tightening in summer, and then will begin to loosen structurally in 2009.

In the longer term, assuming the business cycle rebounds by 2010; if this were to happen analysts forecast that prices will fall in the $70/bbl range. However, this will also hinge on the world’s ability to absorb the new upstream and downstream capacities which are coming online as a result of investments made earlier this decade along with improvements in the politics of Russia, Iran, Iraq, Venezuela or Nigeria which will allow higher output growth. If these events do not happen, oil prices in 2015 could be sharply higher than today.

As a result, 2009 and 2010 could prove to be more of a pause in the commodity cycle rather than a drop, which could lead to an even bigger run-up in prices midway through the next decade.

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