What Rising Oil Prices Hold for 2011

What Rising Oil Prices Hold for 2011

  • 5 January 2011

The price of oil remained rather sedate for most of 2010 but swung to the highest year-end closing since 2007. While oil futures advanced 15 percent its spot price inched towards the $100 per barrel mark. All that happened despite a supply overhang, around 2 percent demand growth and a somewhat uncertain economic outlook – factors that should have neutralized each other instead of causing a spike in oil prices. A dramatic start to the year makes this vital commodity’s progress in 2011 worthy of attention.

From the risk of jeopardizing possible global economic recovery to fueling inflation, hike in oil prices can have major repercussions at different levels. Consumers may have to pay more for fuels and commodities. Air travels may become expensive as airlines re-impose fuel surcharge fees to cover rising jet fuel cost. On the other hand, for an embattled country such as Iraq, this will mean rise in revenues and minimizing deficit. At a policy level, it can lead to even greater emphasis on renewable energy and conservation. There was also that inevitable impact on the Arab stock markets that ended 2010 on an upbeat note over rising oil prices.

The sudden rise is attributable to various short-term factors. Extremely cold weather conditions in the Northern Hemisphere sent Europe and North American consumers scampering for heat supplies. But perhaps the biggest influencing factor is the US Federal Reserve or Fed pumping money into its economy. According to some economists, additional liquidity making it to the markets by the Fed’s Treasury purchases is reaching commodity markets and is causing spike in oil prices.

Weaker US dollar, which is also a direct consequence of the ultra-expansionist monetary, supports dollar-denominated commodities such as oil. Whichever way one looks at it, oil prices are bound to become a barometer of investor sentiment on the state of the global economy.

Reactions vary depending on which way the graph is headed. Consuming countries typically cry foul over the rise while producers and the industry call it ‘fair’. This is probably because both realize that market sentiments and not pure fundamentals are determining its course. Since high oil prices could also impact the global economy, on which oil producers are equally dependent, it is not quite a win-win situation for any.

All these may combine to carry the price of crude beyond $100 a barrel. Add to it the OPEC [The Organization of the Petroleum Exporting Countries] decision to hold production quotas at present levels – even though the demand has recovered to 2008 levels – and there is only one way the price is headed for the moment.

Besides, the commodity is increasingly being used as a mainstream asset class. With low interest rates and high liquidity, investors have been attracted towards oil expecting future demand growth and a belief that OPEC will defend prices.

The influence of financial demand for oil is evident in the fact that financial futures have grown from twice the size of physical oil markets 15 years ago to almost 12 times the size now. With futures trading essentially based on anticipation, market sentiment about the direction of the global economy is likely to override supply and demand fundamentals. As a result, oil prices will remain sensitive to investor sentiment on global economy during 2011, apart from exchange rate movements and China’s battle to control inflation.

OPEC too is sensitive to oil prices responding to non-fundamental factors. The cartel believes it should not pump more if the hike resulted from speculation rather than any supply shortage. “If it goes to $100 due to speculation, OPEC will not move,” Secretary General Abdullah Al-Badri was quoted as saying recently, adding that the organization did not want oil to rise that far. Sadad Al-Husseini, oil analyst and former top official at Saudi Aramco, expressed similar sentiments. “It remains to be seen whether prices are responding to short-term weather conditions or longer term demand and monetary issues,” he said.

Analysts such as Al-Husseini maintain that dollar-denominated oil is cheaper than it seems because the value of the currency has fallen. “Prices have not yet risen to $100 per barrel and there is nothing mysterious about $100. It equates to no more than $80 per barrel in 2005 dollars, once current prices are corrected for inflation.” In the presence of abundant oil inventories, OPEC doesn’t want to over-react on what could be a transient price situation. It also realizes that the demand could also drop by the time extra oil reaches consumers, causing oversupply.

But what lied beneath the spurt in oil prices in the closing weeks of 2010? One school has it that the real story starts with OPEC implementing deep supply cuts to kick-start a price recovery. This gathered momentum as markets began to look at signs of growth, with implications for increased fuel consumption.

The house is also divided on whether the oil price hike will hinder the marginal recovery being witnessed in the global economy. International Monetary Fund (IMF), for instance, does not see the rise as a threat. Its managing director John Lipsky recently said that the energy prices seem to be responding to “strengthening growth relatively close to a range that has appeared consistent with continued expansion in the global economy.”

On the other hand, Saudi Arabian SAMBA’s Oil Market Outlook 2011 says that global recovery has actually helped underpin a strong rebound in oil demand, particularly in emerging markets, and prices have risen 26 percent to average $78.2/b in 2010. “Slowing global economic growth will dampen prospects in 2011, but oil demand will continue to rise and prices are projected to average $82/b,” it says.

Interestingly, this rise in oil demand is mainly emanating from China, India and the Middle East itself. Saudi Arabia is now the second fastest growing oil market after China. Things are not very different in other Gulf Cooperation Council (GCC) countries as well. In fact so rapid has been the recent expansion in domestic oil and gas consumption in GCC that authorities here are looking to curb demand to ensure a steady energy supply over the long-term.

However, there appears to be a consensus over oil crossing $100 a barrel during 2011. As the world watches the oil graph with bated breath, those in the financial markets would see it as the next big trend.  Oil is hot investment for 2011 and, whichever way one looks at it, the words to watch this year with regard to oil prices will be bulls and bears and not demand and supply.