Underlying Factors in the Rise of the Price of Oil

Ioannis Michaletos, Athens, Greece, November 30, 2007

A security officer overlooking a street from a rooftop of the OPEC headquarters in Vienna, Austria. Crude oil has approached but not exceeded $100 a barrel. (Photo: Joe Klamar / AFP-Getty Images)

The dramatic increase in the price of oil over the past few months, which saw the index rising as high as $99.29 a barrel recently, is influenced a great deal by investors in international capital markets that seek to enjoy higher profits by exploiting so-called hedge funds and investing heavily in oil futures that predict a rise in prices. Predictions that take this and a number of other important reasons into consideration are for a higher energy price index over the coming winter months.

The devaluation of the dollar, which is almost 50 percent of the euro, is another factor. Oil is priced in United States dollars in the world markets and the decrease in its value has enabled the transfer of capital from currencies such as the euro or pound Sterling to dollars in order to invest in oil futures and options. Moreover, as long as the dollar loses value there is going to be a steady increase in the price of oil. It is a vicious circle. Along with the devaluation of the dollar, one should include the subprime crisis, which has hit investment houses and banks worldwide and led to the transfer of further funds from an ailing real estate sector to the oil sector in the form of contracts that predict the rise of the commodity.

Another aspect of the increase in prices can be explained by the inability of OPEC to operate as a sole energy cartel. Even though it currently controls some 40 percent of the overall global oil production, only Saudi Arabia, its primary member, has the ability to increase production on short notice to exercise downward pressure on the markets. Further, the entrance in the past few years of all the major investment brokers into the oil trade in the form of futures and options has lowered OPEC's ability to manipulate prices, which it had been able to do relatively easily since the early 1970's. In short, oil has become a truly global investment proposal and, for the time being, competition has had what we would consider an opposite effect and increased the price; albeit, this effect could be reversed if other factors change as well. It is not improbable that oil prices could plummet if investors start to predict a decrease in prices and, in parallel, the oil producing states manage to enlarge their production.

Another element to notice is the various geopolitical ambivalences and conflicts that hinder political stability in a large segment of Eurasia. Iraq, Iran, the Israeli-Palestinian conflict, and the Turkish-Kurdish skirmishes are all concentrated in the center of gravity of the world oil trade, namely the Middle East. In addition, the ambiguity over the intentions of Hugo Chávez in Venezuela and Vladimir Putin in Russia, are some other parameters of the equation. Finally, Nigeria is in a state of a civil war in areas that contain much of its oil. These countries own the bulk of the world's oil resources and until the world order is normalized, at least psychologically, the markets will behave in an upward trend.

Iraq by itself is a major issue, since the production of oil in the country is not sufficient to assure a steady flow to the markets, as was the case before the war. For the moment, there are no signs of a positive development in that regard, and it should be noted that Iraq before the war was the second-largest oil producer in OPEC. Terrorism too—and not just in Iraq—is an unknown factor for oil prices. For instance, with the May 2004 attack on the oil industry complex in Saudi Arabia by Al Qaeda we witnessed a sudden spike in prices, despite the failure of that attack. One wonders what the consequences of a successful terrorist attack in an oil-producing country would be—a hypothesis regularly discussed by security analysts across the globe

Furthermore, over the past generation there has been little investment in the refinery sector of the oil industry. Both the United States and Russia have neglected to invest in their refinery industries. There are also serious considerations about Russia's ability to manage its energy know-how in order to invest in new oil fields as well. Its future plans for oil transfers and new pipelines might just be pipedreams, while the future seams bleak for the market because it cannot wait for long-term investments.

Finally, the great demand for fuel by China and India is a great factor. Since 2004, China has been the second-largest oil consumer, and its accelerating growth of around 10 percent a year seems unstoppable. Because China is in essence a centralized command economy, a prime investment destination and has the largest monetary reserves in the world, it need not worry about a possible recession due to the rising oil prices. China's development is not expected to stall with further oil price increases. Moreover, a large percentage of China's production is coal related. It will be able to finance its expansion even at the expense of environmental destruction with this energy efficient but ecological unfriendly fossil fuel. Overall, oil is not a big issue for China.

The effects of the rise in oil prices are already visible for middle-sized economies, especially those dependent on energy imports. Greece, for example, imported 2.5 percent of its gross national product in oil in 2003, while for the first nine months of 2007 it imported an equivalent of 4 percent. Greece's G.D.P. growth has already shrunk to 3.6 percent for the July-September period, versus 4.6 percent for January-March, according to statistics by the Finance Ministry.

Oil prices will most probably increase further because the multitude of factors that affect it are not about to change in the near future. It is fair to assume that a price of $120 is possible during the coming winter term. On the other hand, some sectors will benefit considerably from this situation. The charter index prices for oil tankers will most certainly benefit since the buyers will be eager to obtain quantities of the commodity so as to forestall a further increase, a situation that rapidly becomes a spiraling response by the markets. Also, investments in gold and other precious metals is traditionally a method of securing assets in times of uncertainty. The real estate sector in the oil-rich regions might also benefit. So too might associated industries, such as machinery and transportation, as well a recruiting companies specializing in energy industry personnel, energy publications, and so on.

The only certainty is that the global markets will never stop operating, and a recession is just an opportunity to reengineer the existing modus operandi of the economic system. Expect also a strong demand for renewable energy resources (solar, wind, biofuel, nuclear) that, if strongly implemented, will reverse the upward trend in oil prices. This kind of development might indeed be the future, and the current state of affairs may indicate that the era of oil is over, despite the mighty role it has now.

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