Monday, January 31, 2011

Don't Blame High Oil Prices On What You May Think.

This is an issue that has stuck me like a thorn for quite awhile.  The first time I heard something like this was from Donald Trump, not my first pick of investment guru, but during the last big oil crisis he stated that there was no current shortage of oil and that full tankers were sitting all over the place. So why was the price of oil going up?  Seems its  was our speculative friends on Wall Street.

Is this the case again?  I hope you find this article informative and it may give you a new perspective.


Crude Oil Prices, Market Fundamentals and the Global Economy

Crude oil prices have over the past three years shown great volatility. Prices for the Brent grade, for example, began 2008 at about $99 per barrel but by the end of that year had tumbled by about two thirds to just under $40 per barrel. For 2009, prices almost doubled between January and December.

The recent surge in crude oil prices, breaching the $100 per barrel mark (Bonny Light $100.12 per barrel on January 17, Tapis $103.36 and Minas $102.21 on January 21), has generated some concern about the rather precarious rebound of the global economy. Many financial analysts hold that another great surge in prices may wipe away a modest recovery.

Calls for OPEC to increase production (in order to stem prices), however, seem unnecessary; first, because the group has been producing significantly above its official ceiling – compliance estimates are between 60% and 65% – and secondly, global stocks are still relatively high, albeit falling. The group currently boasts a spare capacity of about 6 million barrels per day, even as the market is adequately supplied.

That said, several of the major price spikes during the past three years have been in spite of adequate market supply. The spikes were characterized by massive supply overhang and weak demand; even when oil prices surged to more than $145 per barrel in 2008, the markets were well-supplied.

Figure 1 below, for example, shows that in 2009, spot prices for Brent were in the main on an upward trend even when total OECD stocks were rising. The year 2010 was not much different.




During the last few months, the prices of oil have had less to do with its levels of supply and demand than with financial markets. Newly-released U.S. Energy Department data, for example, show that U.S. crude oil stockpiles increased by higher-than-expected (nearly 5 million barrels) values last week, further increasing supply for a second week, while total fuel demand slipped. The immediate effect, contrary to expectations, was a spike in crude oil prices (following a firmer Wall Street instead): Brent for March settlement jumped $2.46 to $97.71 per barrel on the ICE Futures Europe, while crude oil for March delivery rose $1.30 to $87.49 on the New York Mercantile Exchange.

Figure 2 below shows a roughly reciprocal relationship between the strength of the U.S. dollar (with respect to the euro) and crude oil prices for the last 12 months. This is not altogether unexpected for such a dollar-denominated commodity.




In 2009, several market analysts joined the International Energy Agency, IEA, to project an oil price shock by the year 2012 (next year), citing severe supply shortfalls; in my analysis, then, l held that even in the event of a price shock by that time, such shock would most probably show no fundamental support -- and so far that has generally been the case. Yes, to the extent that its global rate of extraction exceeds its natural rate of formation, crude oil is technically a finite resource and now even prone to exploitation constraints set by geology, technology and finance; but before arguments about “peak oil” are let loose, l’d like to add that global oil supplies will most likely not dry out in 2012.

One upside to the recent oil price levels, however, is that capital expenditure (capex) is set to rise. (Some of the analysts who projected a short-term oil supply crunch based their conclusions in the main on low capital expenditure values.) According to the Financial Times, the five largest publicly-listed oil companies are expected to spend a record $128 billion on capital projects during the next 12 months to boost production. It reports that Chevron (CVX) is expected to boost capex by about 20% to $26 billion, while for Exxon (XOM), the value is between $25-$35 billion. Major national oil companies are also expected to increase their capex.

Finally, so much attention has been focused on certain oil “marker” prices, such as $100 per barrel, and their effects on the global economy. What matters more to the global economy, however, is the average oil price over a given year rather than a particular peak price for that year; for example, according to the Energy Information Administration, the average Brent spot price for the year 2008 was $96.94 per barrel (about the same as current prices), even with the much-reviled peak price of $145.66 per barrel for that year. In addition, the rate of increase between years may also be a factor.

Some analysts have proffered oil price “inflexion points” (ranging from $120-130 per barrel) that may prompt a reverse of the current global economic recovery. When prices for global energy – of which petroleum is a significant portion – are very high, economies may be negatively impacted, and where the currencies of such economies have been devalued against the U.S. dollar (oil’s denominated currency), the situation is even compounded. In addition, several aspects of global food production processes are energy-dependent and for many economies, the current food crises only compound spiraling inflation; but the impact of energy subsidies on the global economy could also be just as negative.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

This article was written by Dennis U. Atuanya a seeking alpha contributor.  original article 

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