Energy: The Price of Oil

London, 1 Aug 2008. Crude oil has dropped from its mid-July high of $147 to $123 as of 1 August 2008. Is this merely a Fibonnaci Correction on the way to ever higher prices, or has the air been let out of the oil-dot com bubble?

London, 1 Aug 2008. Crude oil has dropped from its mid-July high of $147 to $123 as of 1 August 2008. Is this merely a Fibonnaci Correction on the way to ever higher prices, or has the air been let out of the oil-dot com bubble?

Following the low of $16 per barrel in January 1999, oil prices have seen a steady rise, breaking all records on July 11, 2008, when prices reached $147.27 per barrel. Although the crude oil prices fell to $123 by 1 Aug, 2008, a significant decline in prices is unlikely, given the current demand scenario and political issues in many of the oil producing nations.

Oil prices are driven by the often complex interplay of supply, demand, processing and distribution costs, US dollar exchange rates, speculation and geo-politics.

Development of new supply sources was constrained until recently by low energy prices, what is now rather wistfully referred to as ‘cheap oil.’ Rising oil and gas prices, particularly since the start of the latest Gulf War, have led to a new economic rulebook and an expansion of drilling and exploration, including previously un-economic sources such as tar sands and deep water drilling. However it takes years to move from exploration to production and refining.

Meanwhile, demand rises year after year. Although demand is dropping in some western countries, the emerging giants of India and China are fast catching up in terms of demand for oil. Add to that growth in Russia, Brazil, the Middle East and a host of other developing countries, and there is no foreseeable end to growth in energy demands.

Hanging over the whole supply-demand equation and a source of long-term nervousness is Peak Oil. Analysts forecast that we are fast reaching peak oil and unless measures are taken to conserve and use alternate sources of fuel, we are headed for oil shortfalls that can only grow year on year.

Although oil demand is projected to increase, production levels should be significantly higher than demand for the next few years at least.

So why are oil prices rising so fast and so high? As well as longer term Peak Oil concerns, the weak US dollar and market speculation are adding demand, supply and pricing pressures. Geopolitical uncertainties are also adding to the concerns. Unrest in Nigeria, the risks of war between US and Iran, instability in Iraq, muscle-flexing in Russia and political disputes with Venezuela are all being factored in to one extent or another.

Indeed some analysts believe that speculators have severely distorted oil prices. In particular, they point to the recent bankruptcy of SemGroup, an oil trader that had large short positions that it was forced to cover, as being a cause of both the run up and pull back in oil prices.

Most observers see this as a short term price correction, however, since demand is only going to grow, while supply is at best uncertain and at worse contracting.

Alternative renewable energy sources are inevitable and vital, but will take even longer to reach critical mass than new oil wells. Short term we face an inevitable crunch, but long term heightened awareness levels are likely to lead to greater energy efficiency and the development of a range of cleaner energy sources.

For the consumer, high oil prices adds to costs both directly and indirectly. The prices of food and other consumer products are directly linked to oil prices. In our increasingly globalized world, products are shipped around the world, sometimes in multiple legs. Petroleum derivatives are also key ingredients for plastic and fertilizer among other things.

As the price of oil rises, so does the price of pretty everything else. At worst, this will lead to both inflation and a constriction on growth, the dreaded scourge of stagflation.

Not only are the retail, transport and consumer goods industries threatened. The very concept of globalization might be at risk if the new baseline cost of energy means it is cheaper to produce and manufacture as close to the consumer as possible.

If the world is going to hell in a handbasket, we may as well make some money on the way down. There are many interesting opportunities for investors to look at, particularly in taking long term positions, but the risk and uncertainty levels are also high. Clearly the successful renewable energy players will experience massive growth, but much of the market is undefined today. ETFs and funds may well prove to be the most compelling options here.

The major oil companies are attracted a lot of attention, both good and bad, but they may not be the best way to play the petroleum sector. Not only are they heavily regulated and taxed in the developed world, they are also being increasingly excluded by developing economy governments, who prefer to place assets under the control of their national oil companies. The oil services companies have benefited greatly from this trend, since national oil companies need both skills and services to develop their own oil fields. The likes of Schlumberger and Haliburton may be the most attractive plays in this sector.

It is very difficult to call where the oil and energy industries will be at ten to twenty years from now, but one thing is for sure; its going to be a bumpy ride.

Jenny MacGraw, EconomyWatch.com