Andrew Page Andrew Page

Not since the oil crisis of the 70’s have we seen such a massive increase in the cost of energy. It was only a year ago that the price of oil was below US$70 per barrel, essentially half the current price. In fact in 2008 alone we have seen oil rise nearly 50% and carve out successive records along the way – in terms of dollar amounts and even inflation adjusted amounts!

There have been a raft of factors at play, but perhaps the most dominant has been the decline of the US dollar. The reason for this is that oil is priced in US dollars, so when the purchasing power of the greenback diminishes, it becomes cheaper for foreign investors to purchase oil. In essence, with all other factors remaining constant, a rise in the price of oil is necessary to off-set the reduced value of the greenback.

Perhaps the longer term influence on oil price is resultant from the interplay of supply and demand. Put simply, the global economy is demanding more of it, while at the same time our reserves are diminishing. It’s an irrefutable fact that there is only a finite amount of oil on our planet, and given that it takes millions of years to form, we cannot expect new oil to be formed any time soon. While a higher price makes previously less desirable, or more difficult, oil more economical, the fact is we are using up our supply much faster than we are able to produce more. Previously oil rich areas such as Texas, Mexico and some parts of Russia have reached and arguably passed “peak oil”.

This doesn’t mean the end is nigh. Our best estimates are that we still have at least 50 years worth of oil left. But because the remaining oil is in difficult to reach spots, or politically unstable regions, we may just have to accept paying more for this precious commodity. Furthermore, traders have been quite nervous over supply issues because of geopolitical tensions and industrial disputes. The most notable examples of this include the ongoing political strife in oil rich Nigeria, and the increasing tension in the Middle East. Political posturing between Iran and the west is certainly not helping to soothe trader’s fears!

The other side of the demand/supply equation is largely explained by the rise of the developing nations. The most important of these are the “BRIC” nations”: Brazil, Russia, India and China. As their economies grow they are demanding more and more oil, and this is adding to the already high demand from the developed nations. Again, this doesn’t mean we are about to run out, but its simple economics that when demand increases, and supply falls (or even is perceived to fall) price inexorably rises.

Another factor at play in recent times has been the large increase in speculative trading on oil contracts. In the past, the majority of transactions in the oil market were between suppliers and those happy to accept delivery of a contract. More recently however, we have seen a very large increase in market participants who are looking to simply profit from the volatility in price. While this in itself can seem like harmless speculation, it can have a big influence on price when large institutions and fund managers start pouring billions of dollars into the market. In fact there have recently been calls for tighter regulation of the markets which would seek to limit the effects this can have.

So the real question is – where to from here? Forecasting commodity prices is tricky at the best of times, and given the seemingly opaque nature of many of the underlying variables involved, it’s probably a near impossible task. But my guess is that we could see oil retreat within the medium term. My rationale is this. Firstly, the US dollar has probably bottomed, or is at least close to the bottom. Interest rate differentials between the major countries are likely to remain mostly steady, as monetary policy in the US starts to move in line with that of Europe and Asia. Also, the economic slowdown in the US has already largely been factored into exchange rates.

Secondly, while demand is increasing from the developing nations, it is probably going to ease somewhat elsewhere as cooling global economies (and the higher price of oil) temper the West’s appetite for oil. On an aggregate basis, demand is almost certainly still likely to rise – but not at a rate that fundamentally justifies a further significant rise in price. On the supply side, while it cannot be argued that we are running out, we still have plenty left. And barring any major conflict or natural disaster, the fundamentals cannot justify a continuation in the current rate of appreciation.

In the author’s humble opinion, it’s unlikely that oil will ever again drop below US$100 / barrel. But at the same time, it will be difficult for it to surpass US$200 / barrel within the next few years, and any rise between current levels and that amount is likely to be a much more steady one than what we’ve seen over the past 12 months. Of course no one really knows for sure, and only time will tell.

Another question that deserves attention is, “what will this mean for the stock market”? And that’s really a whole other kettle of fish, so we will explore that in the next edition.

Until then, happy investing.

Andrew Page