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Crude awakening

A number of supply factors are keeping oil prices high and they could go even higher in the short term

Market view, Andy Weir

The price of crude oil hit an all-time high in New York last month, touching $78.4 a barrel. This is up from below $17 a barrel in November 2001 – an increase of more than 360 per cent in just five years. This huge rise in oil prices has been driven by a number of factors, including geopolitical uncertainty, limited supply and strong demand.

The most obvious cause for the continued high prices comes from the prolonged war in Iraq and the current hostilities in Lebanon. Not only are these conflicts disrupting oil production and delivery in the region but they have also led to concern that the fighting will spread to neighbouring Arab states. If this happened, it could lead to a much more serious disruption in supply – the most notable example being a possible supply interruption from Iran, the world’s fourth-biggest oil supplier.

A further risk to oil supply comes from Latin America as countries such as Venezuela have been pushing Opec to cut production and maintain high prices. They have discovered that political noise will keep prices high, even as their own production drops.

Other short-term shocks which may affect oil prices could include hurricanes such as those which hit the north-central coast of the US in August 2005. They pushed prices higher as oil rigs were severely damaged.

All these supply factors seem to be keeping oil prices high but demand is playing a part, too. Most recently, some commentators have suggested that the thwarted terrorist plot at Heathrow earlier this month may have reduced people’s desire to travel by air. Indeed, on the same day as the plot was aired, crude oil futures dropped by 2 per cent.

In the longer term, China and India have been growing at a rapid rate and have increased demand for petroleum-based products. That said, the growth – while likely to continue – will start to slow in pace at some point. In the western world, plans are also in place to improve efficiency of oil-dependent products such as cars in the UK and US. Many countries are also looking seriously at alternative fuels such as wind, solar and water power which may decrease demand for oil over time.

We could very well see oil prices go even higher in the short term. Some commentators have even speculated that oil at $100 a barrel is not inconceivable. Over the longer term, however, we believe that oil prices may decrease once the current perceived risks have subsided but even then we do not expect them to fall back to the levels seen at the start of this century.

Bonds are often seen as a “safe haven” in times of economic unrest, as investors typically move their capital away from perceived riskier investments. If oil did reach $100 a barrel, we would expect to see political instability and an investment flight to quality ,with global bonds in particular rallying.

A further reason why continued high oil prices may support bonds – at least in the short term – would be that the effect of the prices would be felt by economic growth first before feeding through to inflation as consumers of oil need to have it irrespective of price.

Finally, the other beneficiaries of the sustained high prices have been and will continue to be the emerging market oil producing countries such as Mexico, Russia and Kazakhstan. Not only have these countries – which defaulted as recently as a decade ago – using the extra cash they are making to improve their economies by investing in infrastructure, paying off debt and seeing budget surpluses but they are also increasing production. This means that if supply gets cut off in other parts of the world, they should be able to make up the difference.


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