- Markets & Risk Newsletter
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- Oil Prices Exhibit Continued Volatility Hold on to your hats! The rollercoaster ride of oil prices experienced during the past year may only be beginning. After soaring to a peak in 2008 of US$147 a barrel, prices fell more than 70 percent by the end of the year. This represented the largest percentage decline ever exhibited over a short time period, exceeding even the reversals of 1986.
The severity of the current recession and the rapidity with which global economic conditions changed are without modern precedent. Historically, except for the spikes in 1979 and 2008, when adjusted for inflation the price of oil has hovered around $20 a barrel. As recently as 2003 the price of a barrel was below $25 and, incredibly, in 1998 was below $11, a period when there was a glut in the world oil market. After the bottom fell out in 2008, during the first two quarters of 2009 prices have rebounded to $70 a barrel. The surge reflects a general consensus that the sharpest period of decline in the global economy is over, expectations that the contraction in oil demand may bottom out soon, and that growth in China may be back on track.
But investors know that oil prices are unstable; policy makers around the globe share the concern. On May 27 of this year, French President Nicolas Sarkozy said during a visit to the energy-rich United Arab Emirates, "We have to work together to fight oil price volatility. The volatility of oil prices is not in anyone's interests." What are the forces that promote volatility? -When market conditions are tight and buffers are low, oil prices react very strongly to signals of scarcity. One of the characteristics of the most recent boom was that scarcity was aggravated by persistent supply constraints, as spare capacity had diminished after two decades of substantial excess capacity in the system. -Oil production being inelastic, short-term shifts in the overall global economic outlook provoke a response in oil prices. Changes in underlying economic fundamentals can lead to larger oil price changes in the short term than in the medium term. -During the boom, the investment climate in a number of countries deteriorated, deterring investment. These factors included reserve access terms and policy parameters affecting investment returns including tax policy environment. -International Monetary Fund analysis suggests that late 2007 and early 2008 portfolio investment into commodities represented a contributing factor to the significant rise in oil prices at the time. -New oil fields typically are smaller in size and involve greater geological and technological challenges than in the past. In new fields, costs per barrel for development and exploration are higher in constant dollars than they were when older fields were developed, while time-to-build lags have increased. In addition, in some regions the decline rates of existing fields are faster than expected. -Demand growth has remained consistent because new players have emerged, with growth in China and the Middle East.
Analysts believe that for U.S. oil demand to diminish the price will need to hit $150 per barrel. Oil supplies from producing countries outside the Organization of Petroleum Exporting Countries may plateau within three to five years. With OPEC's annual production decline rates of at least 1.5 million barrels per day and assumed annual global demand growth of 1.5 million b/d, OPEC needs to add at least 15 million b/d of capacity every five years-a goal that OPEC ministers consider to be highly improbable. Given the mix of production and market forces at play, investors anticipate continued volatility in the price of oil, making crude oil futures a game to be played with cool nerves and plenty of research. For information on powerful risk-management tools that allow you to track and measure the risk of global energy markets, contact PortfolioScience today. |
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