Middle East Economic Survey

VOL. LI

No 29

21-July-2008

OIL PRICES

Factors Contributing To The Understanding Of Oil Price Projections

By Salman Ghouri

The following article was written for MEES by Dr Ghouri, Senior Economist, Corporate Planning, with Qatar Petroleum (QP). The views expressed in this article are those of the author and may not reflect the views of QP.

Oil prices have been on the rise for the last five years, and during 2007 we have seen greater volatility and uncertainty in the oil market compared with previous years. Last year WTI prices slumped during January to around $50/B and then increased significantly throughout the year, nearing the $100/B mark before sliding to around $90. With the exception of 2003 and 2007, there has been a general declining trend towards the last quarter of each year. However, in general oil prices have been higher compared to previous years. On an annual average basis oil prices were higher by $10/B in 2004 than in 2003, $14/B higher in 2005, $10/B higher in 2006, and about $6/B higher in 2007. Recently oil prices exceeded $140/B in nominal terms.

Have prices reached a peak and should they now move downward? Although a softening of oil prices has seemed possible a number of times in recent years, it has not happened. Instead prices have continued to drift upwards. Now it appears that a sharp peak is yet to come. The market is sending signals that oil prices could touch $200/B. Is this possible? If yes, what could be the driving factors? Are we running out of oil? Or is something else happening?

Market Behaving Differently Than In The Past

We are aware of the major driving factors that were responsible for elevating oil prices in the past. Some of these factors, which may continue to influence oil markets, are: the geopolitical situation, especially in the Middle East; violence in Nigeria (including the rupturing of crude pipelines and kidnapping of oil workers); strikes in Venezuela; war in Iraq; hurricanes; the Iran nuclear issue; higher demand in China and India; the weaker dollar; speculators; non-OPEC supply; and inadequate investment in exploration and production. Most of these underlying factors are constantly changing, and no-one can predict with confidence what will happen in the near future. In the past, in similar market environments, oil prices have converged to a long-term equilibrium after periods of highs or lows. However, in the current episode the market is behaving differently, with prices remaining surprisingly high over an extended period. A $200/B WTI price is possible only in extreme circumstances – a major crisis in the Middle East – but is not possible on the basis of the current global economy and market fundamentals.

Based on market fundamentals, current oil prices are not likely to be sustainable for an extended period, as high oil prices are like an additional tax on consumers. The world is also now being subjected to major spikes in food prices. In such circumstance how can one expect a scenario of $200/B, especially when the IMF has made significant downward revisions to global GDP and economic growth projections for developed economies? In the past few years governments of many developing countries have provided subsidies to protect domestic consumers and avoid inflation. However, many are now facing huge current account deficits, for some exceeding 7-8% of GDP. Therefore, these countries are constantly under pressure to withdraw subsidies. One could anticipate civil unrest in a number of developing countries in the absence of some urgent actions¹.

Excessive Investment In Futures

The current rising price regime cripples the basic concepts of economics and market fundamentals. This is mainly due to excessive investment in commodity futures markets. In addition to hedge, pension and investment funds, today index speculators are pouring billions of dollars into commodities futures, speculating that prices will increase. The assets allocated to commodity index trading strategies have increased substantially, from $13bn at the end of 2003 to $260bn as of March 2008. Consequently, the prices of the 25 commodities that comprise these indices have also risen by an average of 183% during this period².

Logically, to protect and obtain higher returns, investors could send out market-leading statements, predicting for example that oil prices may reach $200/B. While it is difficult to rationalize the basis for such a forecast, a number of investors and professionals have stated such a view. And by investing billions in oil futures and other commodities, hedge and pension funds, investment banks and index traders have sent out ‘wrong’ market signals, and in turn oil prices continue to drift upwards. Is there an end to it? Or are we waiting for doomsday – a global recession perhaps even more severe than that in the 1930s?

Inadequate Investment Opportunities

I am not trying to blame investors. The simple philosophy of any investor is to maximize returns. Investment opportunities have been limited after the crash of the US housing industry due to the subprime mortgage crisis. Additionally, continuous weakening of the dollar induces investors, traders, and hedge and pension funds to buy oil futures and other commodities as an alternative opportunity. Cuts in US interest rates further exacerbated the situation, adding to the speculative buying. US Federal Reserve interest rate cuts are also causing many investors to turn away from the US dollar, further weakening its value. The Fed began cutting in September 2007 in an effort to ease turmoil in the housing and mortgage markets. I think this was a much-needed step for the revival of the housing industry, which is the backbone of the US economy. However, the Fed failed to counter the consequences of cutting interest rates aggressively.

Weaker US Dollar

In addition to declining US interest rates, depreciation of the US dollar has also contributed to rising oil prices. The dollar’s value has fallen over 70% against the euro from May 2001 to May 2008, forcing investors to swap their dollars for other, stronger currencies and commodities, such as oil, gold, wheat and corn. Since oil is traded in dollars, petroleum traders around the world have demanded higher prices to make up for the decline. No doubt there is a strong negative correlation between the oil prices and weaker dollar.

In a comparison of daily WTI prices from 1 January 2000 to 20 April 2008 against the dollar/euro exchange rate, it has been shown that a weakening of the dollar by 1% led to an increase in oil prices by 1.56%, other factors remaining constant. In contrast, oil prices in euros continue to dwindle in response to the weaker dollar – making oil relatively cheaper in euro-denominated economies. The euro, the British pound and the Japanese yen have strengthened significantly against the US dollar since 2001. Towards the end of 2007, the euro, the pound and the yen had appreciated against the US dollar by 53%, 39% and 3.23%, respectively, as compared to 2001. For example, at the end of 2007, the average WTI oil price of $72.20/B equated to a price of €52.66/B, ie 37% cheaper for European consumers than in 2001.

Oil producing countries receive their payments in US dollars irrespective of the final destination of their exports. OPEC countries suffer most. For example, during 2007, out of total exports worth $13.85 trillion, 37% and 28% respectively was directed to Europe and Asia. In the same year, OPEC countries imported US$14.1 trillion worth of goods and services from around the world. However, they imported $5.27 trillion and $3.58 trillion worth of goods and services respectively from Western Europe and Asia. That is, they had to pay relatively more in terms of US dollars earned to import a particular quantity, compared with when the dollar was strong – causing a substantial rise in domestic inflation. Therefore, to offset this loss, oil producers looked for better oil prices. I think countries pegged to the US dollar should rationalize their exchange rates, monetary and fiscal policies to counter the impact of rising inflation. The combination of these policies simultaneously should help in easing the inflation rate to certain extent.

Is $200/B Oil Just Around The Corner?

Before drawing any conclusions about $200/B oil, one needs to ask honestly whether the current high price regime is sustainable over an extended period of time. In my opinion the answer is certainly no, for a number of reasons. Persistent high oil prices are already affecting a number of developed and developing countries and this in turn reduces oil demand. US oil demand is expected to slow further due to weaker economic growth, gloomier consumer sentiment, and the sluggish housing industry. The housing industry is the backbone of the US economy, although it only contributes 5% of GDP. The increasing housing inventory has slowed down new construction activity, and that in turn severely affects a large number of other directly or indirectly associated industries. A stagnant housing sector leads to higher unemployment and further weakens consumer sentiment. The weaker dollar has helped in boosting exports, but it also reduces US imports, which in turn affects the exports of its major trading partners – Japan, China and Europe. Any crisis in the US would thus soon spread into other economies.

How the effects of higher oil prices and the US financial crisis are impacting the prospects of global economies is highlighted in the table. Since October 2007, the IMF has revised downwards its forecast for 2008 global GDP growth.

Comparison Of Recent IMF GDP Growth Projections

Source: Various IMF reports.

In the past few decades, especially from the mid-1980s to the late-1990s, oil prices remained low and therefore failed to induce investments in oil and gas exploration. However, in response to persistent higher oil prices, the industry has since reacted positively. For example, exploration and production (E&P) spending increased from $94bn in 2003 to over $324bn in 2007 and is expected to be about $355bn in 2008. ExxonMobil has already invested over $60bn in E&P during the last four years and is expected to bring 20 new oil and gas projects on-stream by 2010. OPEC members also committed to invest over $150bn to enhance their oil production capacity to about 40mn b/d by 2010. After the lifting of sanctions on Libya a number of US and other companies are exploring new and redeveloping existing fields using state-of-the-art technology. A significant boost in exploration efforts in West Africa, North America, Central and South America, Canada and FSU will enhance global oil production. As a result of this much needed boost in exploration a number of oil fields in the US deepwater Gulf of Mexico have been discovered and are gradually being brought into production. The oil industry did respond to higher oil prices, but normally it takes years before the discovered fields are brought into production. Therefore the efforts of the oil industry are expected to bring some tangible results in the coming years. 

Current oil supply is sufficient to meet current and projected demand, therefore oil prices should have decreased. However, Saudi Arabia has recently increased oil production to ease market sentiments, but so far it has not influenced the market and oil prices continue drifting upwards. In addition to these factors, persistent higher oil prices also encourage non-conventional oil developments and investment in alternative sources of energies and energy conservation. The combination of these factors should negate the concept of a $200/B oil price even in the short-term.

Remedial Measures

What needs to be done to tackle such a situation, especially when the global economy is moving towards recession and there is increasing concern over the availability of basic foods? I think we need to address the root cause. The US economy is the global engine of growth and the US dollar is the global currency, despite its recent weakening. In the past the US has rescued the global economy – now it is high time for the global economy to reciprocate. The recovery of the US economy is in the interest of the whole world. For a short-term remedy, people are talking about linking crude oil prices to the euro. Is it possible? I don’t think it would be easy or wise, and it is difficult to assess the potential fallout. At the end of 2007, 64% of global central bank reserves were held in US dollars, and 86% of all global daily currency transactions were carried out in US dollars. All oil and other commodities trade is carried out in US dollars. We cannot and should not try to change this mechanism, at least in the short term.

The question is, how to strengthen the US dollar? First, Asian trading partners of the US should allow their currencies to appreciate against the dollar – making their exports more expensive in the US. The US already has a huge trade deficit with China and it is growing. China’s yuan has since 1995 only appreciated by 18%, enabling Chinese products to remain cheap and boosting US-bound exports – creating huge trade imbalances. Appreciation of the Chinese currency would help US manufacturers to compete effectively and would boost exports to reduce the trade balance. Increased US exports would automatically rejuvenate domestic manufacturing, creating jobs and improving consumer sentiment. One might ask why Asian countries and in particular China should strengthen their currencies, making their exports costlier and hurting their own manufacturing industry. This is necessary for the survival of their export based industries in the long-run, as the US will remain the largest and single most attractive market for the global economy if it is economically healthy. If the US economy gets trapped into a prolonged recession, the fallout would impact many of these economies. Second, the US government might introduce legislation to prevent unethical investments in oil futures and other commodities. Third, increased US government expenditure to create more jobs should improve consumers’ income and confidence. Fourth, the US government should take emergency measures to revive the housing industry and increase bond/long-term interest rate yields, to attract foreign capital, or provide additional tax relief to attract back foreign capital that had flowed out due to low returns.

Notes:

1.   According to the World Bank, food prices have risen by 83% in the last three years, leading to widening malnutrition and civil unrest in several countries.

2.   Testimony of Michael W Masters, Managing Member/Portfolio Manager, Masters Capital Management LLC, before the Committee on Homeland Security and Governmental Affairs, US Senate 20 May 2008.