Friday, April 29, 2011

Where's The Oil?

As I drive home from work these days, the thing I often hear on the radio is gasoline prices have changed, and unfortunately mostly upward. The price for regular gas had risen to nearly $4.00 per gallon from $3.00 in January. I wonder whether I should switch to riding a motorcycle to save more per fill-up, or stop driving altogather and use public transport.

Price Curve

After a relatively stable year in 2010, crude oil prices started to climb above U.S $90 per barrel late last year, following improved global economic growth prospects. Prices have continued to rise, accelerated by events in the Middle East and North Africa.

History reminds us that past oil shocks were all started in the Middle East, ranging from the Arab oil embargo of 1973, the Iranian revolution in 1978-79 and Saddam Hussein's invasion of Kuwait in 1990. Higher oil prices and recessions often are highly correlated.

According to the April outlook from the US Energy Information Administration, Middle East and North African countries supplied about 30 million barrels per day in 2010, or more than one-third of the estimated total worldwide daily supply. Although Libya only produces about 2% of the total and the size of the supply disruption is small compared to past oil supply shocks, fears of political upheaval in other countries in the region, such as Iran and Saudi Arabia, have already sent oil prices up almost 30% since early February.

The price of crude oil is expected to remain between $100 and $150 per barrel in 2011 and 2012. But if political and military events worsen, the price could top $150 in 2011 and $200 in 2012. These prices would destroy the fragile pace of the global recovery _ the IMF projects the world economy will grow 4.4% this year, down from 5% in 2010.

Are we entering another oil shock?

It is useful to look at the past episodes.

The first oil shock started in 1973. After Arab countries launched a massive attack on Israel in October 1973 and the US provided support to Israel, the Opec countries retaliated by reducing oil production and announced a total embargo on oil deliveries to the US, which later extended to Western Europe and Japan. This event tripled the price of oil from $4 per barrel to $12 per barrel, creating a wave of stagflation throughout the developed world.

Mohammad Reza Pahlavi

The second oil shock occurred in the wake of the Iranian Revolution and was sparked by the ousting of the Shah of Iran, Mohammad Reza Pahlavi. The revolution disrupted oil supplies and the price of oil tripled to $36 a barrel. Almost everyone at the time predicted oil prices would continue to increase. On the contrary, after 1980, oil prices started a long-term decline, and prices fell back to $12.

Recently in 2008, the world oil markets again experienced extreme fluctuation (see graph above). Crude oil prices rose to almost $150 per barrel by the middle of the year, a result of tightening oil market conditions and speculative trading in the market, and later plunged to about $40 per barrel in December.

Oil prices are volatile because it is a commodity whose prices fluctuate depending on supply and demand as well as speculation.

I am not too worried about the persistent upside risks of oil prices. For a start, developed countries are much less vulnerable today compared to past oil shocks as they have significantly decreased the amount of oil used per unit of output. And although emerging economies tend to use more oil per unit of output than developed nations, oil usage has been falling, as industries have become more efficient and the service sector, which uses less energy, has become a larger part of the economy.

Any further increase in oil prices will also lead naturally to a slowdown in the global economy, especially if the political crisis in the Middle East and Africa spreads and disrupts oil supply. Oil rising above $150 per barrel could lead to another global recession, reducing oil demand and pushing down the price of oil.

If geopolitical risks do not worsen, a poor sovereign debt outlook and weak real estate markets in advanced economies will continue to weigh down oil's growth prospects, while emerging economies' overheating asset markets provide further downside risk to world growth. Consumers like myself and others would adjust to higher oil prices by consuming less.

The combination of these factors may not embody the whole truth about future oil prices, but should at least take away fears of the next oil shock.

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