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Jesmond Mizzi, Chairman, and Gregory Inglott, Analyst, at Jesmond Mizzi Financial Services Limited
Oil prices in general have a major impact on the performance of financial markets. Higher oil prices exert pressure on both companies and countries as a whole to produce higher output as a direct consequence of higher costs. One must however, keep in mind that certain companies are more affected by higher oil prices than others. Furthermore, higher oil prices cause a crunch in domestic/household income. Consequently consumer spending in most circumstances is also negatively affected. Given these important considerations oil remains one of the most closely watched variables.
Depending on the quality and type, oil prices have risen by an average of 45 per cent over the last year. Light Sweet Crude has risen form $21pb to $42pb an increase of 100 per cent. (see graphs).
OPEC realising that such high oil prices could damage the world economy passed a resolution on the 3rd of June to increase oil production by 2 million barrels a day. This news quickly filtered into the markets and caused a widespread sell off. Oil is now trading around the 10 per cent lower than their recent highs. The question remains, have we seen the highs or will oil prices return to higher levels in the near future? What are the principal drivers and will they persist?
Unfortunately, oil prices are being driven by structural deficiencies and the more worrying events that are unfolding in the Middle East, which could have a longer-term impact on the global oil markets. Growing political tension in the Middle East – primarily in Iraq and Saudi Arabia – has led to fears that oil supplies coming out of this region could be temporarily disrupted. The current US coalition in Iraq is supposed to hand over power to a local established government at the end of June. There are fears that this could lead to internal struggles and thus increase the potential for oil supply disruptions out of Iraq. Iraqi production is currently about 2 million barrels a day. Added to this, Saudi Arabia has become a focal point for Islamic militants as seen most recently with the targeting of foreign nationals working in the country. The fear again is that increased militancy could lead to greater instability within the country. Moreover, because Saudi Arabia has the largest oil reserves and is a swing producer, any supply disruption emanating from the country would have a disastrous impact on the global oil market.
Speculative activity in the oil-futures markets has increased significantly and is primarily driven by hedge funds. There is a current premium on oil prices that is being driven by speculation, though the exact value is difficult to quantify. Analysts have estimated that it is easily between USD 6–9 a barrel and more likely skewed toward the upper band. This speculative aspect gained momentum on a strong non-farm payrolls report catapulted the price of oil higher based on the assumption that the economy is improving and the Fed will begin raising rates. In turn it bolstered the outlook for fuel consumption in general.
In conjunction with the above point, a structurally inefficient market in the USA that has been compounded by low inventories and strong demand as the US economy has gathered momentum over the last 12 months. Furthermore, the traditional US driving season has commenced, and this will boost demand for gasoline higher during the summer months. As with oil, gasoline, and later heating oil, inventories are below historical levels, and this adds additional pricing pressure to oil and to the price consumers must pay for gasoline.
Finally legislative and infrastructural deficiencies could add further worries. Legislations are being passed by countries banning certain substances from fuel (e.g. sulphur) Refiners have been slow to adapt to these new requirements causing supply problems. These issues could act as a ratchet to increase refined oil prices.
What is the likely implication of these factors for future oil prices? It is almost a fact that terrorism is here to stay. Whilst most countries have surged their attempt to stamp out this threat, fears still remain. This places the market in a position of anticipation of supply shortages as a result of terror attacks. Consequently oil prices retain this upward pressure.
There has been a lot of conjecture that OPEC is not in a position to increase production and thus boost oil supplies. Analysts and OPEC itself have commented that there is excess capacity from the cartel as a whole, but the majority of this excess capacity will come from Saudi Arabia – the swing producer. The kingdom is said to have the ability to raise production up to 10 million barrels of oil a day at short notice. This eases most of the supply worries that have arisen over the last few months.
Over the short term, oil is expected to fall off the recent highs following the increase in oil supply by OPEC. However over the longer term both the risks associated with terrorism as well as the fact that global demand for oil in on the rise (especially from China and Japan) will keep prices buoyant.
This article does not intend to give investment advice and the contents therein should not be construed as such. Readers are encouraged to seek professional advice regarding their personal financial situation. Jesmond Mizzi Financial Services Limited is licensed to conduct investment services by the Malta Financial Services Authority. Email: info@jmfs.net
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