Factors affecting oil prices

Here is an interesting article which is quite interesting.

Why oil is on the boil
By Jayant Manglik, Business Line, New Delhi, July 20, 2008

A look at factors affecting oil prices and the view from both sides of the fence - those who speak of exponential price increases and the ones who see them falling. In the problem of high crude oil price lies the solution. Crude oil news is usually frequent and occasionally dominant - as has been the case in the last few days.

The overreaching effect of the price of crude oil is something no one can ignore. And I guess when the price of something forces the Prime Minister of a country to address the nation; surely it's time to ask why. Oil prices have been increasing consistently for the last seven years and their seeming price-inelasticity and the ability to repeatedly make historical highs has spooked the most adventurous of analysts. Some have simply decided to speak of exponential price increases. An equal number are doubly sure that the price will fall from here on. The factors affecting the price and the view from both sides of the fence are enumerated below; take your pick.

Geo-political tensions seem to go hand-in-hand with oil exporting countries and heightened tensions are the cause of many a spike which takes a long while to die down. The price bulls point to a particularly disturbed environment in the Gulf and Nigeria today, while the bears argue that while the post 9/11 period was rough, it is relatively steady today. But the simmering tensions worldwide do keep oil on the boil.

Global demand continues to grow year-on-year. No argument on this but then again, whether demand growth will sustain is a matter of debate. The jury is still out on whether Chinese (and Asian) growth will slow down and statistics are being bandied about to prove it one way or the other. But it is pertinent to highlight here that till now there is no evidence to prove that high Crude oil prices have led to decrease in its consumption - yet. Perhaps growth in China, India, Brazil, Russia and other fast-growing nations more than makes up for the potential drop in demand from the US on account of its recessionary phase.

Supply issues are central to the whole debate. Surely the world is not out of oil but the last few years have had a Reserve Replacement Ratio of less than one - which is jargon for saying that more oil is being drilled out of the ground than is being discovered.

Considering that we're good for another couple of hundred years in terms of already discovered oil, I assume there is nothing to worry about but in a shortage situation any reason is enough to warrant panic. However, in a high-demand situation, every factor will get exaggerated and put upward pressure on prices.

Immediate oil availability is certainly a matter of concern. After the oil price tanked to $11 per barrel in the late 1990s, all plans of new refineries were shelved and expansion stopped. Today, the shortage of refineries has become a bottleneck in that even if enough Crude oil is pumped, there is just not enough refining capacity available to process it into end-use products such as petrol and diesel. This is likely to change as early as next year when several refineries worldwide start coming online, led by our very own Reliance Petroleum. But till then, refiners have upped their margins, making for costlier end products.

The newly acquired prosperity of several nations, including India, has played its part in convincing oil exporting countries to raise prices to levels the market can absorb. This is evident from the fact that crude oil prices have grown in tandem with increasing world GDP growth in the last few years and the increasing affluence has ensured that price increases are taken in stride. Whether the current levels are sustainable or not is something only time will tell but as of now crude prices continue to rise incessantly.

The strength of the US Dollar, or the lack of it, has aggravated the problem. Since Crude oil is denominated in dollars, a weak dollar may be forcing exporters to increase the prices of their product to 'make up' for the loss vis-A-vis other currencies such as the Euro and the Yen.

Because about 30 per cent of the world's production comes from OPEC countries, this is now accepted as one of the reasons for the recent price increase. As a corollary, crude oil prices are expected to fall as and when the dollar gains in strength, once the US is out of the financial quagmire it has dug itself into.

Financial investment is variously estimated to have fuelled the top 10 to 20 per cent of the price increase at any time. In other words, blame futures trading - something we are already adept at in India!

The fact is that, according to the US agency that monitors this, the speculative position percentage of the entire trading basket has remained the same over the last several years. More money has flowed in as investment, yes, but this is offset by increased consumption, trading and prices.

In problem lies solution too So till where can the prices go and when and how will things change? While it is impossible to define what price is too high to be absorbed by the world markets, it is also a certainty that the number exists! And at that level, high prices will stabilise before falling.

Therefore, high prices are not only the problem but also the solution. The increase in crude prices has led to more money being pumped into oil exploration, new technologies to increase production even from marginal fields and new investment into refineries, besides political pressure on oil exporting nations to produce more. High crude prices at a point become counter-productive if they lead to de-growth in user countries. So there will either be additional supply or demand will be adjusted to bring prices to acceptable levels.

OPEC-inspired price increases ended when they realised that high crude prices in the late nineties had wounded the East Asian countries, which were showing rapid growth till then, and OPEC was forced to increase production due to falling demand set about by high prices. This move, in fact, sent prices into a downward spiral (low demand and low prices).

It is entirely possible that the petering out of world GDP growth in recent months is partly on account of high-energy prices. But I wouldn't recommend taking a short position on crude oil futures just yet; one spike in prices could dent your bank balance severely!