AROOJ ASGHAR (arooj.asghar@hotmail.com)
Mar 31 - Apr 06, 2008

Oil has broken through the landmark $100 a barrel in early 2008 rather is setting new records almost everyday, driven by a slumping dollar, geopolitical instability and worries over a winter fuel supply crunch. The price of crude oil has set a fresh record at $109.72, its fifth day in a row of historic highs in first half of March 2008. New York light sweet crude fell back after hitting the high to close at $108.75. London Brent set a record at $105.82, before retreating to $105.25. A recent slide in the dollar is one factor behind the rally in oil prices. Some investors are buying oil to protect themselves against the continuously weakening dollar.

The continuous rises are causing worries in importing countries about the economic cost of higher energy prices. Higher fuel prices cause rises in inflation, restrict economic growth and are considered as unpopular decision among voters. Major oil exporters are divided between those such as Saudi Arabia and Kuwait that favour lifting output in an attempt to ease prices, and those such as Venezuela that argue against such moves which will benefit big consumers, principally the US.

Various reports have attributed this rise to different reasons, but which is correct? Some say it is because the OPEC cartel which they might further cut their production. Others say it is because of fears that Venezuela may stop working with Western oil companies due to differences with the US policy. It may have been sparked off by regular explosion on oil fields either in Iraq or at Alon Refinery in Texas, USA. But the truth is, it could be something completely different. In order to understand the whole issue, one has to analysis why prices are so high.

The fundamentals - Most of the energy consultants worldwide ask "Why did it happen in 2008? Nobody really knows for a fact what's happening or where it's going. While a number of experts believe that it is the fundamentals which are wrong. The fundamentals are the factors that influence the supply of, and demand for, oil. Things such as the increasing demand from China and India, as well as fears that a stand-off between the US and Iran could interrupt supplies, have been raising the oil prices. Alternatively, financial factors may also be the contributing factors, such as a trader deciding to sell the contract above $100 a barrel to get the publicity. The real issue is most of the fundamental information is not freely available. It is said that the market moves on the signals from the fundamentals. Some of them are irrelevant, some of them are wrong, some of them are meaningless, but they affect prices nevertheless. When the New York oil price broke through $100 a barrel for the first time at the start of 2008, one of the factors cited as being behind it was the assassination of Benazir Bhutto in Pakistan on 27 December 2007. Wall Street Journal says that this assassination didn't strike US nor has nothing to do with the production, consumption or supply of oil worldwide thus had no sense to correlate these events together. Moreover, people are too keen to attribute market moves to geopolitical factors like rocket testing in North Korea (previously cited as a reason for rising prices) or the assassination of Benazir Bhutto. Some of the factors that are more likely to influence oil supply and demand, such as figures of oil demand from China, are not available. That means that minor news of fundamentals, such as the output of a single refinery, may be given too much weight.

Rising demand - Expansion in the global economy is driving what the International Energy Agency says is the biggest increase in oil demand for 24 years. It is said that there is higher than expected demand in industrialized countries whereas China's rapidly expanding economy has created a huge demand boost which is up by almost 20% over the past year. Traders are betting this rapid growth will continue for several years although there is some chance that the economy will overheat and oil demand growth will come down. Despite this huge demand, among suppliers only Saudi Arabia has the spare capacity that it can make available to the market on short notice.

Low Stocks - Continuous increase in oil prices has also put huge burden on any company's working capital capacity which is dealing in oil. The worst sufferers are the companies which have to maintain oil stocks while consuming relatively cheap oil and filling reserves with expensive oil. Due to this, oil companies have tried to become more efficient in recent years and operate with lower stocks of crude oil. This means there is less of a cushion in the market against supply interruptions. Events such as violence in the Middle East, ethnic tension in Nigeria and strikes in Venezuela have had a greater effect on prices in the past year than might have been the case if stock levels were higher.

OPEC Strategy - OPEC, the cartel of oil producers', accounts for about half of the world's crude oil exports and attempts to keep the prices roughly where they want either by squeezing or supplying supplies to the market. In the past, OPEC used to wait for prices to drop before they cut the output. But now things have changed, OPEC is now acting more aggressively, announcing production cuts to pre-empt any weakening in prices. In past, oil companies traditionally rebuilt their stock when there was weaker demand and prices were lower but it is difficult to do this now.

Action of Speculators - Due to high oil prices, companies are facing difficulty in maintaining oil stocks thus expose the market to sudden change in prices. Needless to say that this is one factor which attract most to the professional market speculators. Hedge funds and other speculators bet on higher prices which build pressure in the market in return. Number of OPEC officials tends to blame speculators for 2008's run-up in prices, ignoring the organization's earlier role in preventing stock rebuilding.

Violence in the Middle East - The world's major oil consumers remain dependent on the Middle East for their oil. Recent violence in Iraq and probable US attack on Iran only to save Israel has raised fears about an interruption to supplies. Iraqi exports have been cut by sabotage attacks on oil facilities. The reduction in supplies has been relatively modest but it has caused some doubts about Iraq's longer term prospects of becoming a large and stable oil exporter. Probable US war with Iran which is highly controversial has also increased tensions in the region particularly and worldwide in general. Any attack on Iran will be a major event for world oil markets and world economy might not be able to stand on its foot in at least medium term.

Other Political tension - Analysts also view political tension in non-Middle East states Nigeria and Venezuela as having the potential to disrupt exports and drive up world prices. Venezuela is against US policies and there is no easy solution to this tension. It might also be interesting to note that though Venezuela is an oil rich country but it can't stand on its own against US. There must be some backing by any other country which is not being highlighted due to fear of new cold war.

Dollar devaluation - Oil prices are at record levels only in dollar terms, but not in other currencies. The euro replaced most major European currencies at the end of 2001. Oil prices in Japanese yen are still low by historical standards. This shows that while US oil prices are near to record levels, those in Japan are less than half the prices that prevailed between 1980 and 1982. They are also less than the prices between 1982 and 1985 and equal to the 1976 oil prices. Drilling activities are highly correlated with oil prices. As oil prices rise, the rig count increases and vice versa. Although drilling activities lag behind oil prices, the lag differs from period to period and from one region to another. However, looking at world total hides the impact of currency exchange rates and other regional economic and political factors. The trend in total world rig count follows that of the US rig count, which represents about half the world's total. Dollar devaluation increases inflation in the oil producing countries. Statistical analysis indicates that, among 18 oil producing countries, inflation was associated with dollar depreciation in 14. The four countries that did not fit this pattern were those with diversified economies, other major sources of income beside oil, and currencies not pegged to the US dollar. Statistical analysis also shows that dollar depreciation reduces the purchasing power of the oil producing countries. Dollar devaluation affects OPEC members differently. OPEC states have different trading partners. Countries that import more from the US stand to lose less than countries that receive most of their imports from Europe and Japan. The geographic location of some OPEC members plays an important role in determining their purchasing power. Venezuela stands to lose the least from dollar devaluation. A large percentage of its imports come from the US. By contrast, Indonesia is far away from the US and close to Japan. A large percentage of Indonesia's imports come from Japan. Dollar depreciation hurts Indonesia more than Venezuela. Dollar devaluation makes oil relatively cheap in countries with non-dollar appreciating currencies such as the euro and yen.

Looking beyond 2008, market conditions will depend on trends in consumption and production capacity. World oil consumption is expected to grow by 1.3 million bbl/d in both 2008 and 2009, in response to higher projected oil prices and increased risks of a global economic slowdown. Many people, including environmentalists, insist that world ought to convert its energy supply into non-petroleum sources. Such sources include wind turbines, solar panels, and bio-diesel fuel. These three sources of energy are renewable and clean. Wind turbines can be strategically placed near sea shores. Solar panels could replace on roofs of homes and businesses. Bio-diesel fuel is compatible with any diesel engine, from cars to trucks. Many people complain that alternative sources of energy such as solar panels are very costly. While this is true, if enough people bought into these products, prices would come down. Companies would be doing more business, and thus would find ways to lower production costs. In the meantime, while solar panels are still expensive, the governments should offer a tax incentive to investors who invest in these products. Moreover, dollar depreciation reduces activities in upstream through different channels including increased cost, higher inflation rates, lower purchasing power, and lower return on investment. Dollar devaluation increases oil demand in countries with appreciated currencies because of an increase in purchasing power. Large dollar devaluation reduces the supply of oil and increases the demand for oil. It is difficult to forecast the oil prices but based on the prevailing global environment, it can be safely said that oil prices will stay high for a longer period than analysts expect.