Black gold: The price of oil looks set to continue rising in the long term

As a net importer of oil as well as a producer, Egypt is sensitive to the ups and downs of the global crude market. This is especially true given that the government heavily subsidies the price of petrol. And, to the extent that native oil is sold on the local market, producers are compensated based on prevailing world prices. In an era when oil prices are at a relative high, this can have an impact on the country’s economic growth prospects.

HISTORICAL TRENDS: In the 30 years from 1973 until 2003, oil traded almost exclusively within a range of $10 to $40 per barrel. In the last decade prices have risen from an average of around $30/b in 2000-03 to $97/b in 2008. Although they subsided to a degree during the downturn that followed the financial crisis in 2008-09, they have subsequently recovered.

Peak oil theorists simply assert that oil is a finite resource that is being consumed voraciously by the global economy. This argument is predicated on a fundamental shortage of supply and excess demand. However, supply and demand factors alone are insufficient to fully explain the new high oil price paradigm. There are several other factors that feed into the price of a barrel of oil, affecting the global market in different ways. To gain a sense of the trajectory of prices, it is necessary to understand these.

THE EFFECTIVE PRICE OF OIL: Firstly, some of the price increase is related to exchange rate fluctuations. As oil prices are usually quoted in dollars, the strength of the dollar must be considered to understand the effective price. Since 2001 the dollar has depreciated by 24% against the IMF’s Special Drawing Rights (SDR), which is essentially a basket of major world currencies. Therefore, part of the increase in the dollar price is a result of the depreciation of the dollar. Additionally, the effects of inflation driving prices higher should also be considered. Since 2001, inflation in the US has averaged 2.3%.

Therefore, adjusting prices for the effects of inflation and exchange rates, the underlying price of oil in terms of 2001 money would have risen from $24/b to $64/b in 2008, as opposed to the actual nominal average price of $97/b in 2008. Even after taking account of these exchange rate effects, the increase in prices is substantial, at around 15% a year, and requires further explanation. Since 2008 the dollar has appreciated marginally against the SDR, slightly reversing the effects of previous years, and inflation has been moderate. Recent high oil prices are, therefore, relatively unaffected by these factors.

Taking a longer view reveals that current real oil prices are at historical highs. Oil prices adjusted for inflation to 2008 dollars show that, since 1973, the real oil price only exceeded $40/b during the price spikes in the 1970s. However, oil prices only reached around $70/b in 2008 dollars in the late 1970s compared with average prices in 2008 of $97/b. Therefore, real oil prices today are higher than they were when the market lost 6.5m barrels per day (bpd) of oil production as two of the world’s largest producers, Iran and Iraq, went to war with each other.

SUPPLY & DEMAND: Supply and demand in the global oil market has been broadly in equilibrium for a number of years. However, it remains vulnerable to fluctuations in prices relating to short-term shocks or concerns. The International Energy Agency (IEA) estimates that both global oil demand and supply are close to 90m bpd. In recent years the market has tended to be marginally oversupplied, including 2008, the year of the oil price spike, when supply exceeded demand by an average of 0.1m bpd. Total supply and demand volumes, therefore, do little to explain the extent of the increase in average oil prices.

In addition, the market is buffered by stocks on the demand side and spare capacity on the supply side. The major consuming countries generally keep ample stocks. The IEA measures oil stocks in countries that are part of the OECD, a grouping of 34 of the largest developed economies that are mostly net oil consumers, accounting for around half of world oil demand. OECD stocks are well over 4bn barrels, have risen in recent years and are large enough to meet demand for over 90 days.

On the supply side, there is some spare capacity among producing countries, which enables them to adjust production in line with changes in demand. OPEC, a grouping of 12 major oil exporters, accounts for 40% of world supply. Within OPEC spare capacity has recently been averaging around 5m bpd.

SPARE CAPACITY: The combination of plentiful stocks in consuming nations and enough spare capacity to respond to all but the largest of supply shocks should provide markets with some comfort.

However, the fact that around 0.6m bpd of OPEC’s stated spare capacity is in Iraq, Nigeria and Venezuela – locations with a high level of mismanagement – draws into question whether spare capacity increments are attainable. Additionally, around 3m bpd of spare capacity is in Saudi Arabia, leaving OPEC dangerously dependent on a single country. Therefore, a sustained supply shock of more than 4m bpd or a rapid increase in oil demand could leave the market short of supplies. As it takes considerable time to bring new oil supplies on-stream, these short-term shocks do pose a serious risk to oil markets.

PRODUCTION ADJUSTMENTS: Another consideration for oil markets is OPEC production policy. OPEC adjusts production according to its view of world markets. It may cut production if it feels oil prices are too low, or are in danger of collapsing, and it may increase production if oil prices are getting too high. The mere perception that OPEC would probably cut production if prices fell far below its broadly recognised target level of $75/b is enough to provide permanent support to prices.

On the upside, OPEC might regard oil prices as too high if they began to undermine demand for oil by encouraging consumers to switch to alternatives. High oil prices could also act as a break on global economic growth by adding to the cost of investment and expansion. Slower growth would reduce demand for oil. OPEC officials have expressed concern about oil prices reaching $150/b. Prices at this level could seriously undermine global growth, particularly with the global economy still in fragilerecovery mode following the 2009 world recession. OPEC may increase its production in response to supply shocks. The last substantial response to a supply shock was during the 1990-91 Gulf War. In 1989, prior to Iraq’s invasion of Kuwait, the combined production in the two countries was around 4.8m bpd. Their production was decimated by the war and Saddam Hussein’s decision to set Kuwait’s oil wells on fire. Production in the two countries fell by 4.3m bpd to around 0.5m bpd in 1991.

The response within OPEC resulted in oil supply increasing from an average of 22.5m bpd in 1989 to 23.7m bpd in 1991. Therefore, OPEC’s members with the exception of Iraq and Kuwait, increased production by 5m bpd. The bulk of this increase came from Saudi Arabia where production rose by 3.2m bpd. Other countries that were able to make increments were Iran and the UAE, which both added 0.6m bpd.

A more recent supply shock was the almost total cessation of production in Libya at the outset of its civil war in 2011. However, OPEC’s response to the Libya crisis was muted. The crisis began to unfold in February 2011 and by April, OPEC production had fallen by 1.2m bpd, which was the same as the amount of Libyan production that had gone offline (Libya is a member of OPEC). In effect, OPEC did little to compensate for the lost Libyan production. However, OPEC argued that lower Libyan production coincided with a soft period for demand and that increases in production were therefore not required.

The comparison of OPEC’s response to the crisis in Libya and during the Gulf War illustrates the scale of the shock that is required to elicit a response from OPEC. In the case of Libya, Saudi Arabia had the capacity available to increase production, but initially did not deem it necessary to utilise this spare capacity given the economic climate. However, it subsequently increased production in response to concerns about the global economic recovery.

SHORT-TERM SUPPLY CHANGES: The impact of high oil prices on the global economic recovery is of greater concern to producers and consumers than small supply disruptions. Persistent high prices in 2011 prompted oil-consuming countries to take action to avert a potential threat to the fragile economic recovery. The IEA, a grouping of oil-importing countries, took the decision in mid-2011 to release 60m barrels of strategic reserves onto the market over 30 days, only the third time in history that this has happened. While prices fell by $8/b, within days they regained their former level, illustrating that short-term supply changes can have an impact on prices but there are other factors that are sustaining prices at their current high levels.

OECD STOCKS: Overall, stocks in the OECD remain plentiful, enough to cover 93 days of forward demand, a figure that has been rising in recent years. The release of 60m barrels represented 4.6% of OECD government inventories of crude oil, but only 1.4% of government and industry inventories of crude oil and petroleum products. While this is a small proportion, it leaves the potential for OECD governments to release reserves onto the market. Total reserves are currently around 100m barrels higher than in 2008. However, the release of further reserves is unlikely given the limited impact of the previous release and the risk of eroding stockpiles.

There are some long-term factors that could contribute to lower oil prices in the future, however. There is potential for large production increments in Iraq, as its oil industry recovers. The country has targets of as high as 8m bpd, up from around 2.6m bpd currently, although 5m bpd would be closer to consensus expectations. Major offshore discoveries in Brazil have broken new technical ground by extracting from beneath a 2-km layer of salt. These discoveries are expected to double Brazil’s production from around 2m to 4m bpd by 2020. Smaller producers have begun to contribute a steady amount to global production, while areas further north, including Canada and the Arctic, offer sizeable potential.

The Arctic is thought to hold around one-fourth of the world’s undiscovered reserves, with an estimated 90bn barrels of recoverable oil and around 30% of undiscovered gas. Development of these reserves is not expected to be technically challenging, but the pristine nature of the region raises environmental costs. Moreover, any exploration in the Arctic area will require large initial investments to establish the necessary infrastructure. Therefore, the cost of extraction will be relatively high.

CONSUMPTION GROWTH: On the demand side, oil consumption growth in Asia is strong and is likely to stay that way as economic growth remains robust and the rapid expansion of car ownership continues. Demand in OECD countries has fallen to below 46m bpd from 49m bpd in 2007. This has mainly been a consequence of moves towards alternative fuels, including biofuels. The US and Brazil are leading in the production of biofuels, followed by the EU. Some estimates see biofuels accounting for 9% of global supply by 2030, compared with 3% currently.

Overall, global oil demand is rising at around 0.6% per year, or an average of 0.55m bpd. Major increments in Brazil and Iraq, alongside the developments elsewhere, should be sufficient to meet relatively slowly rising demand until at least 2020. Therefore, it is difficult to explain the rise in oil prices during the 2000s through supply and demand factors alone. The market is well balanced and there has been no substantial increase in the tightness of supply and demand in oil markets between the two periods. Furthermore, stocks and spare capacity are higher than their levels at the beginning of the decade.

SUPPLY RISK PREMIUM: Political risk is a factor that has contributed to higher prices. Risks related to the Arab uprisings in 2011 led to a gradual increase in prices from an average of $96/b in January 2011, when the Tunisian uprising began, to $124/b in April, when Libyan production went offline.

This illustrates the market response to risk. Around 36% of world oil production takes place in the Middle East and North Africa. An increase in political risk in this region has a considerable and commensurate impact on oil prices. A minor disruption of supply (such as that in Libya) alongside the credible threat of a major supply disruption in Saudi Arabia added $10-30/b to the price of oil.

There are several sources of possible future political risk. Saudi Arabia poses the greatest threat as it has the bulk of global spare capacity and around 10% of production, and while the country is relatively stable, any disruption there would have profound implications. Rebels with political grievances are a challenge in countries such as Nigeria, which produced around 2.45m bpd of oil and condensate in 2011. Between 2006 and 2009, oil companies and their installations in the Niger Delta were targeted, with pipelines sabotaged and personnel kidnapped. At the height of the insurgency, the country was on some days producing as little as 800,000 bpd. Output levels are back up following the introduction of the amnesty programme in 2009, but the potential for unrest in this region is a persistent risk factor that oil markets take into account (see analysis).

INVESTMENT IN OIL-RELATED MARKETS: Investment in oil markets has contributed to higher prices. In recent years, oil has increasingly been treated as a financial asset by investors and speculators. It has been used to hedge against the risk of inflation as there is a self-reinforcing correlation between oil prices and inflation. It has also been used as a hedge against a depreciating dollar, as the oil price tends to increase as the dollar depreciates. Additionally, it has been used as a straightforward bet on the global economy. A strong global economy generally implies strong oil demand growth and an increase in prices. This link has led to oil prices becoming more closely correlated to the general market sentiment of investors and speculators.

Expectations about the global economy can be measured by movements in world stock markets. In 2009-11, the correlation between global stock markets (measured by MSCI’s World Index) and oil prices was over 90%. In 2007 and 2008 it was over 80%. In 2000-06 there was no consistent correlation and the relationship was often inverse. This suggests oil prices are affected by market sentiment and that investors and speculators are, therefore, an important factor driving price changes. Based on industry surveys, it has been reported that, in a rising market, 25-40% of the price of a barrel of oil is the result of speculative inflows into oil markets.

FUTURES MARKETS: Financiers are able to gain exposure to changes in the oil price by investing in futures markets, meaning they do not need to take delivery of physical oil as they can close out the contracts at a profit or loss before the delivery date.

This has created a futures derivative market that is considerably larger than the actual market for physically deliverable oil. The value of outstanding futures contracts in oil markets continued to set new records throughout the 2000s and is currently running at about $30bn per month.

It is likely that increased investment in the oil market has led to price volatility, which, measured as standard deviation, rose exponentially during the 2000s, from 3.2 in 2001 to a peak of 29 in 2008. Volatility currently remains about five times above its levels in the early 2000s. Because oil is so fundamental to modern economies, high volatility of oil prices has a destabilising effect on the global economy. High oil prices also have negative consequences.

There is widespread concern about the detrimental impact of high oil prices on the global economic recovery. The spike in 2008 led to widespread petroleum riots. Higher oil prices have also resulted in food inflation, which has been cited as an important factor in causing the Middle East unrest in 2011. Because oil is a necessary element in the production and distribution of such a wide range of goods, its price has a major impact on global inflation. The correlation between oil and global consumer prices was 83% during the 2000-10 period, which is, statistically, highly significant.

SUBSIDIES: In some countries, including Egypt, the impact of high oil prices is born by the government, which subsidises the price of fuel at the petrol pump. As of early 2012, the cost of a litre of 90-octane gasoline in Egypt stood at about LE1.75 ($0.29). This puts a heavy burden on the government, with 32% of all spending in the fiscal 2011/12 budget accounted for by energy subsidies, according to research by the American Chamber of Commerce in Egypt, but this figure includes subsidies for natural gas, as well.

In a high oil price environment, the burden of subsidisation becomes acute and can have a dampening effect on economic growth. The IMF has estimated that in developed economies a $40/b rise in oil prices would lower growth by 0.75 percentage points. It expects growth would be 0.5 percentage points lower in sub-Saharan Africa and Latin America. In the Middle East and former USSR, real GDP growth would increase, as oil producing countries tend to pump more oil in response to higher prices.

However, global growth could be seriously impaired if high prices persisted for five years or so at levels of around $150/b. High oil prices in the long term will fuel troublesome inflationary pressures, forcing central banks to raise interest rates, which will further dampen growth. Worries about asset price bubbles in Asia have led to tightening of interest rate policy ahead of some other regions.

COST COMPONENTS: The price of a barrel roughly breaks down into 28% cost of exploration, production and transport; an investment and speculation cost of 33%; a risk premium of 18%; and a premium for inflexible supply and demand growth of 21%.

These factors mean that the upward direction of pricing is unlikely to change in the future. The premium for inflexible supply and demand growth is likely to remain largely unchanged, given the unofficial OPEC target of $75/b and the tolerance shown by importing countries for this price.

The cost of exploration, production and transport of oil is rising, as more technically difficult oil becomes increasingly necessary. With much of world production taking place in areas of high political risk, the risk premium is unlikely to shift significantly.

Investment and speculation may drive oil prices down in times of heightened financial risk, or when the outlook for the global economy is poor. However, this is likely to be short-lived as confidence in financial markets and the global economy returns. As a result, the high prices are very likely here to stay.