Business

Monday March 10, 2008

The oil price conundrum

IN PERSPECTIVE BY BALJEET GREWAL



THE relentless rise in oil prices, perpetuated in large part by insatiable global demand, underlies a crucial principle: that the dream of energy independence is a delusion.

The potent mixture of robust demand, limited spare capacity and multiple threats to supply that are now driving the market is the precursor to a world supply-demand imbalance.

Assuming investors were told in 2001 – when economic momentum was bottoming out – that the price of oil would more than triple in five years, they would probably have envisaged a world economic meltdown of epic proportions. Prices hit a new high of US$106 per barrel last week – a similar scale of price peaks in 1973/74, 1979/80 and 1989/90, all of which were followed by global recessions and rising inflationary pressure.

Today, however, global GDP growth is well above market dynamics. This is despite looming inflationary pressure. (It’s probably worth noting at this point that weak economic dynamics in the US was not a result of high oil prices, but a symptom of a defective US financial system). Why has the world economy fared relatively well this time despite high commodity prices?

Economic analysis reveals the following:

·The pace at which oil prices have risen has been gradual – far unlike the drastic “oil-shock” periods of the '70s and '80s which saw oil prices triple in a span of five months. This paced increase has allowed consumers and businesses time to adjust; hence marginal disruptions to confidence and economic activity.

·Global cost of production is still lower than the price of oil when adjusted for price inflation. Hence, in real terms, oil prices are within manageable levels.

·The “oil-shocks” in the past were triggered by supply disruptions in the form of Opec (Organisation of Petroleum Exporting Countries) embargos, Iran revolution, Iraq invading Kuwait, etc. This time around, although there remains persistent supply threats in the form of Russia’s pipeline, Iran’s impeding nuclear programme and so on, the rise in oil prices is predominantly driven by increasing demand.

The core to understanding oil price fundamentals lies in three broad areas: the primary demand-supply balance, hedge funds/speculative positions driving prices, and the wild card of geopolitical disruptions. The market today is more focused on event risk, and the fact that any small disruption in production, due to the thinness of refinery capacity, could lead to a short-term hiccup.

Global oil demand has increased from 70 million barrels per day (bpd) to above 86 million bpd in the past 10 years. Equally, the American oil addiction is a genuine problem.

While inefficient oil consumption of China and India remains vast, they only account for 15% of total world output. The US accounts for 25% of total global oil demand, guzzling at an insatiable pace far outstripping emerging countries.

China’s oil imports have moderated so far this year as it is taking a stance not to accumulate reserves when oil prices are high. Also, the move to employ more efficient use of oil in China and India is likely to see sustained demand without “energy shocks”.

The concern is more with the supply of oil – world oil supply has more or less halved in the last decade, largely due to political risks and old and over-exploited mega-fields that are becoming less productive.

Nevertheless, new sources of oil (non-Opec) have also emerged as important players, namely Russia (producing 11% of world oil output), Mexico, the African region, etc. Higher prices might also herald substantially higher investment to enhance efficiency and thus, long-term supply.

In the interim period, there is no risk that we are running out of oil, but the chances of being able to match the estimated growth in demand over the medium term with a rise in production is being seriously questioned – and increasingly factored into the oil price conundrum.

The impact of speculation/political risks on oil prices is far more challenging to determine. About 30% to 35% of oil prices currently are estimated to be speculative in nature, particularly through oil hedge funds, which are aggressively shoring up prices. However, speculative positions don’t last long and it is expected that when the pace of growth in China slows post-Olympics, hedge funds will gradually exit the oil market, which will see prices stabilise themselves.

The crude oil price upward cycle may extend over several years in response to changes in demand as well as Opec and non-Opec supply. In the meantime, expect a three-digit oil price to surface several times over the first half of this year on the back of continued strong demand for oil as the primary energy source as well as risk to supply arising from security threats and the availability of refining capacities.

  • The writer is group chief economist at Kuwait Finance House, Malaysia (KFH). KFH is one of the largest Islamic banks in the world and the first Islamic bank with an economic and investment research team.

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