$100/barrel oil has gone from sensationalist claim to credible
reality. Little more than a year ago, Goldman Sachs was castigated
for releasing what was then seen as a self-serving report warning
that oil could see a 'super spike', with crude prices reaching as
high as $105/barrel. One year on and the front month crude contract
on the New York Mercantile Exchange is averaging above $65/barrel
for the year to date, after hitting an all time high on Apr 21 of
$75.35/barrel.
Earlier projections assumed that a serious supply disruption
would be necessary to move prices so high, yet the market has
reached nearly $75/barrel oil through a combination of expectations
about Iran, continued volatility in Iraqi security and output and a
particularly bad spate of militia violence in Nigeria.
In short, the market has reached nearly $75/barrel without the
realization of a disastrous supply event, even if the previous high
was a result of the massive dislocation caused by the devastating
2005 US Gulf hurricane season.
Chart: Correlation between open
interest and NYMEX crude
Adequate supply
The physical market's lack of relevance is reflected in the loss
of OPEC's ability to moderate price behavior. In addition, the price
structure for international crude benchmark Brent Blend has for some
time been that prices for forward delivery are higher than for
prompt. This is unnatural for a high-volume low-price commodity that
is expensive to store and, again, indicates no shortage of physical
crude. Furthermore, crude and oil product inventories in the US and
for the OECD as a whole remain at healthy levels.
Futures reflect the price of oil decided by demand for a
primarily financial contract. There is nothing fundamental to the
market in terms of costs of production or return on capital that
decides whether the price of oil settles one day at $70/barrel,
$80/barrel or indeed $100/barrel. It depends on the amount of money
with which market players are willing to back long and short
positions.
In the run up to the May 2 high, the movement of the IPE Brent
crude contract lead that of the physical Dated Brent marker. IPE
Brent's peaks and troughs were generally higher and lower
respectively than Dated Brent's. Given no shortage of physical
crude, the only explanation is that the physical market's leverage
on price is temporarily in abeyance, or is periodically being
overridden by a futures market driven by a huge influx of capital
and living off future levels of risk rather than the immediate
supply/demand balance.
Inflation impact
While the rise in crude prices, as well as other commodities, has
broken all previous assumptions, what has been equally surprising
has been the lack of impact of high energy prices on world growth.
An oil shock of this proportion should have caused widespread
inflation, resulting in higher interest rates, which in turn would
have put a break on world trade and thus the continued rise in
demand for crude.
Instead inflation in both the developed and developing worlds has
pretty much been kept under control. Manufacturers have been unable
to pass on increased energy prices to consumers and have instead had
to accept reduced margins, which have largely been achieved through
control of labor costs. This has been helped by the shift in the
manufacturing base to countries like China, and has also given
impetus to the process. In addition, oil prices before the recent
rise were historically cheap when adjusted for inflation, which
meant that the proportion of consumers' disposable income affected
by a rise in oil prices was less significant during the current oil
shock than previously.
However, there are signs that any slack there was has now been
exhausted. Industries and economies based on raw material processing
will eventually have to pass rising energy costs on to consumers. In
the US, expectations about average inflation rates have risen from
2.3% in January to 2.8% in May, having already moved up from a low
of 1.6% in early 2003. The expected rate of inflation is at the very
top of the band with which the Federal Reserve is comfortable.
Consumers' expectations about future inflation are also rising
because prices are climbing persistently faster than officially
announced rates of inflation. Official price indices strip out
energy costs and make other adjustments that mean measured inflation
is lower than the cost of living increase experienced by families.
When energy prices rise fast that anomaly becomes more readily
apparent and begins to shape expectations about future inflation.
This means that there are two processes underway; the rebuilding
of surplus crude capacity and the gradual slowing of demand growth
as a result of substitution, but also potentially slowing world
growth as a consequence of tighter than currently expected monetary
conditions instigated to reign in inflation. These are slow
processes and will evolve over a two to five-year time period in
which physical world crude markets will stay in a delicate balance.
During this period, prices will remain exposed to any disruption to
supply, while price volatility will be magnified through the
marginal price setting of futures markets where the link to physical
markets has become increasingly elastic and erratic. As a result,
$100/barrel is a real possibility.
Created: May 16, 2006
NOTE: Please note the date and
price published in the first paragraph of this feature has been
corrected from May 2 and $74.10 to Apr 21 and $75.35.
This is an extract from a feature
article on the formation and impact of high oil prices that will
appear in the June 1 edition of
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