At a time when world oil supply is meeting demand, why has there been such a rapid price rise? The current crude oil price is up by approximately 40 per cent in the past year, prompting major concerns about the impact on economic recovery and expansion. Changes in the oil price may have far-reaching effects on financial markets as well. Let us, therefore, examine some of the issues currently driving the price.
Fear and uncertainty
Fear and uncertainty are undoubtedly the principle reason for recent price movements. While the risk premium is hard to measure, many analysts believe that this factor alone is responsible for adding somewhere in the region of 10 dollars to the price per barrel. The current uncertainties stem from several quarters, namely, the ongoing Iraq crisis, recent terror attacks in Saudi Arabia, civil and political disruption in Nigeria and Venezuela, and the problems faced by the Russian oil giant, Yukos.
The world’s major oil consumers are heavily dependant on the Middle East for their oil, and recent violence in both Saudi and Iraq have raised fears of an interruption to supplies. Recent news from Iraq is that oil flows to terminals on the Persian Gulf and from northern Iraq to Turkey have increased significantly. This has helped to ease oil prices from a high of almost $50 per barrel in August to current levels of almost $44 (New York light crude) and $40.62 (London Brent crude). However, a fresh attack last week on Iraq’s northern pipeline increased market anxiety once again.
Saudi Arabia, the world’s largest oil exporter, is currently meeting demand with a surplus production capacity estimated at approximately one million barrels daily. In the immediate aftermath of the terrorist attack on expatriate oil workers in Saudi Arabia in May this year, we saw the oil price rise by http:// per barrel. This was seen as an attempt to undermine the current regime and to produce anxiety in the oil markets. With significant security measures and back up systems in place, the risk that any individual terrorist attack will seriously disrupt oil production in the Kingdom is therefore very low. Having said that, there is little doubt that any significant interruption in oil production from Saudi Arabia will cause widespread panic.
Adding to recent uncertainties was the concern that the Russian oil company, Yukos, which is estimated to pump two per cent of the world’s oil, would have to cease production because of a massive tax demand from the Russian government. An announcement on August 23 that Yukos intends to increase output by six per cent this year helped contribute towards a fall in oil prices in late August. Now, however, a court has ordered its bank accounts to be frozen and this has once again put future production under threat.
Finally, civil unrest in Nigeria and the aftermath of the re-election of President Chavez in Venezuela are being monitored closely. These have also been seen as factors in the threat to supply which could potentially lead to an increase in the oil price.
Increasing economic expansion in China and India, combined with the continued economic recovery in the US, is a major driving factor in the current high demand for oil. In particular, the rapid economic growth in China, estimated at around nine per cent for 2004, has seen their demand for oil increase by 40 per cent in the first six months of 2003. China is now the world’s second largest oil consumer importing one third of its demand, whereas in previous years China was a net exporter. This level of demand from the Chinese economy at a time when oil prices are soaring has resulted in significant increases in the Chinese inflation rate. Now, the Chinese authorities have taken steps to reduce the rate of economic expansion and it is felt this should ease pressure on the oil price as demand gradually reduces.
Speculators in the oil futures market, who buy options to purchase oil at a fixed price in the future, do so in the anticipation that oil will rise in price. More speculators predicting such a rise will result in a higher demand for these options and thus contribute to a rising oil price. Hedge funds are playing an increasing role in the futures market accounting for somewhere in the region of nine per cent of the market. It is hard to quantify the extent of influence that hedge funds have had on rising prices but that they are a contributing factor is not in question.
So what is the impact of rising oil prices?It can probably be broken down into three main areas:
The impact of increasing oil prices on inflation is seen initially through rising fuel and energy costs. Firms will seek to pass these rising costs onto the consumer and the response from the work force will be to seek higher wages.
At a time when profit margins are under pressure from rising energy costs which firms are unable to pass on to the consumer, firms will attempt to cut costs elsewhere, often resulting in firms seeking to reduce labour costs. A reduction in employment will inevitably result in a slow down in demand, which in turn leads to a downturn in economic growth. Rising oil prices present a very serious threat to global recovery. It is estimated that each http://www.0 rise in the price of oil takes 0.5 per cent off world GDP growth.
3.Shift to alternative fuels
A sustained rise in the cost of oil should prompt more intensive research into alternative fuels, but worryingly this is not always the case. Undoubtedly, countries like America would prefer to be less reliant on a form of energy which is dependent on the co-operation of politically unstable organizations, but we have yet to see any meaningful effort to adjust this balance. We should all remember that oil is a finite resource, and with world demand at a peak, the time seems right for governments to step up their research into the more replaceable alternatives.
• With the uncertainty of what lies ahead for our energy supplies, it is important to ensure that your investment strategy has been adapted to meet the challenges of our ever-changing world.For further information, please contact Susan Hart at Close International Private Banking in Almancil Tel: 289 395 077 or e-mail [email protected] – website www.closeipb.com