Growth in demand, a fall in supply and increased investment in oil have combined to drive prices up, writes Paul Harris.
FISHERMEN ARE blockading ports around the State and hauliers are threatening to do the same. Across Europe, similar protests are taking place. Airlines are warning of reduced profits and increased fares, while US motorists are coming to terms with prices at the pump in excess of $4 a gallon for the first time.
French president Nicolas Sarkozy is calling on EU leaders to take action to soften the blow - by reducing the level of VAT on fuel - from what he sees as an unprecedented shock on the global economy. But what is the true state of the oil market?
Crude oil has risen by 42 per cent this year, with indications that the top of the market has yet to be reached. Goldman Sachs, which originally forecast $100 per barrel of oil, recently issued a forecast of $200 a barrel, with many analysts predicting prices will breach the $150 level soon. Earlier this week Russian energy giant Gazprom predicted $250 a barrel.
The question is whether these forecasts have credence or whether they are the self-serving projections of interested parties. What are the real dynamics at play in the oil markets?
Price fundamentals are borne out of relative supply and demand: oil is no different. Oil demand growth over the past five years has increased as the global economy has enjoyed above-trend growth.
Oil prices, which were around $20 a barrel in 2002, have reflected the increased thirst for oil from buoyant economies.
However, developing nations have continued to grow their industrial capacity, with India and China accounting for half the increase in demand growth. This marks a structural change to the demand side of the oil picture and, while demand from Organisation for Economic Co-operation and Development (OECD) countries is slowing in the wake of higher prices, oil imports in Asian countries continue to grow.
The International Energy Agency has cut demand growth projections for 2008 to about 1.03 million barrels a day in OECD countries, yet figures from China this week reveal a 25 per cent increase in oil imports, associated with stockpiling ahead of the Olympics and relief efforts following the Sichuan earthquake.
It is unlikely that the rate of economic growth in the region will fall dramatically - even with further oil price rises - and so the global demand picture will remain significantly unchanged.
On the supply side, the producers' cartel, Opec, is resolute that production levels are correct and that the rise in prices is reflective of the weaker dollar and speculative activity. In spite of global representations from consuming nations, Opec remains unmoved.
Key to this intransigence is the fact that the weak dollar has eroded the purchasing power of oil-producing nations and an offsetting rise in oil prices means their net position is balanced. Additionally, non-Opec production has fallen, notably in Russia, further squeezing the demand-supply gap.
Geopolitical events add bullish impetus. The market is sensitive to real or perceived threats to supply. Tensions in the Middle East endure - the most recent threats by Israel against Iran precipitated intraday rises of $11 a barrel.
Perhaps the most telling assessment of the demand-supply picture was delivered earlier this week with the publication of BP's 2008 Statistical Review of World Energy. It reported a fall in global oil production of 0.2 per cent, the first fall in five years, with a corresponding increase in consumption of 1.1 per cent. These simple statistics give credence to the rise in oil.
The ascent in oil prices from $20 a barrel in 2002 has not gone unnoticed by investors. The emergence of commodities as tradable assets has attracted significant funds into the market. In the wake of the credit crunch, returns in oil are attractive and huge volumes of monies flowing into oil have underpinned prices globally. The malaise in the dollar has prompted additional funds to flow into oil as an "inflation hedge", and the inverse correlation between the dollar and crude oil has increased since last October.
This so-called "speculative influence on price" cited by Opec as a key factor behind the rises probably accounts for about $25 to $30 of the current crude oil price.
There is also a structural dimension to the oil price rises of the past five years. In the 1980s, the forecasts for oil prices were low - $12 a barrel - and infrastructure investment was virtually nil. Consequently, equipment in the refineries is old and inefficient. Frequent maintenance periods, both unscheduled and scheduled, present a supply disruption risk.
The costs of exploration and refinery construction are considerable and will feed into prices.
The lack of investment in exploration has exacerbated "peak oil" situations, where large fields are nearing the end of their productive cycles. The peak oil theory - that we are consuming a finite commodity at an accelerating rate - has long been the preserve of the green lobby. However, the issue is now mainstream and the emergence of energy security as a key concern underpins the rationale for investment and adds to the upward impetus of prices.
The rest of 2008 is set to see continuing volatility, with a further grind higher. While governments have tried to adjust demand through the removal of subsidies (Asia) and investigations into speculative oil trading (US), it remains to be seen whether these initiatives will succeed. The Saudi-brokered summit later this month is doomed to fail if, as is likely, the participants maintain their respective stances.
The upcoming US hurricane season may deliver further record prices if, as forecast, there are production interruptions. Such price volatility will quickly erase any respite engineered by governments.
The upward trend in oil prices will continue on the basis of market fundamentals. However, the weight of investment pouring into oil will ensure the pace of the rise continues to accelerate.
Paul Harris is head of natural resources risk management, Bank of Ireland Global Markets
