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September 2004 / No. 31


Oil & Gas

Pouring Oil on the Flames

OPEC has put the blame for the rising oil price largely on speculative excess. According to this argument, large purchases by hedge funds have been responsible for pushing up the price.

In recent months prices of oil and petrol have been climbing very fast indeed, and on August 20th the price of West Texas Intermediate, the American benchmark crude, reached yet another new high of around $49 a barrel. A bubble, many have said. Some are not so sure. There are good reasons to suppose that the world will have to get used to a high oil price for a good many years yet. Why might this be so? And what might it mean for the price of financial assets?

OPEC has put the blame for the rising oil price largely on speculative excess. According to this argument, large purchases by hedge funds, those free-wheeling pariahs of international finance, have been responsible for pushing up the price—witness the growth in speculative positions on the New York Mercantile Exchange. When the hedge funds cut and run, the argument goes, the oil price will fall. If this line of thinking had any merit to start with, it would seem to have been somewhat undermined in recent weeks by the fact that the price has continued to rise even as those positions have been reduced.

In any case, long-term consumers clearly do not believe that the oil price will fall much. When the spot price (i.e. for immediate delivery) has soared in the past, the forward price (for delivery in the future) has barely budged, because consumers expected the price to fall again: in October 2000, when the spot price reached $38, the forward price stayed at $20. This time, the forward price has climbed sharply too: the price of oil for delivery in ten years’ time has reached $35 a barrel.

Perhaps buyers are willing to pay this apparently heady price because it is, it transpires, not so elevated after all. Since January 2000, the average price of oil has been about $30, points out Jeffrey Currie, head of commodity research at Goldman Sachs. The only time in that period that it has fallen below that price for any length of time was immediately after the terrorist attacks on September 11th 2001.

Tragic Geography: An unexpected increase in demand from a growing world economy, in particular from China, has helped push the oil price up. So have growing worries about supply. The world still relies heavily on exports from Saudi Arabia, an unpleasant, apparently unstable country in a region where things are bad and getting worse. Alas for oil consumers, the Middle East does not have a monopoly on instability: from Russia to Venezuela, fate has decided to hide oil under some pretty unsavory countries. The oil price has climbed further of late as the troubles of these two countries in particular have bubbled to the surface.

Car companies and (especially) airlines might best be taken off the menu. Shares in both have already lost around 20% of their value this year, compared with a fall of some 4% in the S&P 500.

But these supply worries reflect deeper problems of under-investment, argues Currie. There has been no growth in pumping and refining capacity since the 1970s; all the growth in output of the past three decades has come from squeezing more oil out of existing fields. Last year, growth in demand outstripped growth in refining capacity by 15:1. The rise in the oil price is both a reflection of past under-investment and, of course, a spur to future investment. It will, however, need oil to stay above $30 a barrel for several years to solve these supply problems.

What a high and rising oil price might mean for the world economy is the subject of much debate among economists. The sanguine point out that the price is still considerably lower in real terms than it was when it hit giddy heights in the 1970s. And rich countries are, moreover, less dependent on the stuff than they used to be. However, the more nervous, worry about the situation in America. An increase in gasoline prices acts as a tax. And this sharply higher tax is being forced through just as interest rates are rising and fiscal policy is being tightened.

American households are already stretched, with debt-service costs at record levels. It should therefore come as little surprise that the economy is showing signs of weakness. The message from the Treasury-bond market, which tends to thrive on slow growth and low interest rates, is not a heartening one: yields are little higher than they were at the beginning of last year. Weaker growth might, of course, translate into weaker demand and thus lower oil prices, at least briefly. But clearly that point has not yet arrived. And governments and companies will probably take advantage of any drop in the oil price to build up stocks, thereby putting upward pressure on the price.

Splitting the Tab: The big question for financial markets is: who will pay the tax that a higher oil price represents? Clearly, America as a whole will fork out in some way because it is a net importer of oil, and the effects of the rise in the oil price are greater there because gasoline is taxed so lightly and oil is denominated in dollars, a currency that shows every sign of weakening further. It is, of course, a moot point whether it will be mainly consumers or companies who pick up the tab. In the 1970s the tax was paid for largely by consumers in the form of inflation, which ate away at the worth of any investment with fixed returns. But this time inflation is muted, for now at least: consumer prices actually fell in July. This may be because, with the world economy now so interconnected, companies find it hard to push up prices.

If consumers do not pick up the full tab, companies will have to pick up some of it through lower margins. There is plenty of room for them to do so because profits are at record highs. Falling profits are unlikely to be anything but baleful for a stockmarket that is generously valued and under pressure from rising interest rates. Any industry heavily exposed to a high oil price and falling consumption would not seem the most toothsome of investments. Possibly, then, car companies and (especially) airlines might best be taken off the menu. Shares in both have already lost around 20% of their value this year, compared with a fall of some 4% in the S&P 500.

 

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