Oil price to rise gradually as global recovery begins

ECONOMICS:Political and economic factors as well as unpredictable elements will determine price, writes PAUL HARRIS

LAST YEAR, Brent crude oil was trading at record highs of $148 a barrel, with oil producers predicting the breach of $200 a barrel by the end of the year. Six months later, following financial meltdown and the onset of global recession, crude oil prices languished approximately 70 per cent lower.

Today Brent crude sits in a $60 to $70 a barrel range which has prevailed since early May. While the market remains volatile – most recently illustrated by last week’s spike to $73.50 a barrel, prompted by the actions of a London-based rogue trader – the question for manufacturing and transport businesses is one of direction or long-term trend. What are the drivers that will prove key directional influences in the oil market in the months ahead?

Unsurprisingly, the prime factor behind oil prices remains the health of the global economy: higher economic activity necessarily means greater consumption of oil, and higher consumption pressurises supply channels, raising prices.

For the oil markets, the economic health of the US and China, the largest oil consumers, is paramount. Since January, traders have watched closely as tentative signs of recovery in the US have begun to emerge. Last week’s surprisingly weak non-farm payrolls precipitated a sharp reversal in the oil markets, underlining this relationship. Until a consecutive series of positive economic data releases emanate from the US, it is difficult to envisage a resumption of a bullish tone to the market based on purely economic factors.

Interestingly, a key factor behind the spike to record levels last year was the buoyant developing economies of India and China. These countries expect growth this year of 5.7 per cent and 7 per cent respectively, contrasting with the OECD countries’ forecast of -3 per cent. In the event that the global economies rebound faster than expected, oil demand from China and India may yet prove a factor in accelerating oil price rises.

US economic health is also fundamentally important for Europe. Should the US return to growth faster than Europe, prompting an accelerated tightening of interest-rate policy, the dollar may well strengthen in tandem with oil prices, bucking recent trends.

This would expose Europe to relatively higher oil prices, given that the commodity is dollar-denominated. It is worth remembering that Europe was insulated from the true extent of oil price rises in 2008 due to the strength of the euro.

Opec’s response to a drop in world oil demand of about 0.4 million barrels a day has been crucial. The cartel reacted to the global slump last year by paring back production quotas which have been well-observed. Removal of supply is unlikely to be reversed until well into 2010.

A range of $80 to $85 has been often quoted by Opec members as the desired equilibrium price and, as global recovery continues with supply unchanged, prices will inevitably rise.

While economic factors will dominate the trend in the near term, it is important to consider the impact that price spikes have on the market. These spikes threaten supply and will therefore affect prices.

Geopolitical events are liable to push markets higher, particularly if they directly threaten significant supply.

The unrest in Nigeria prompted by terrorists has seen a number of direct attacks against oil pipelines adding $2 to a barrel.

Of greater importance will be developments in the Middle East this summer. The re-election of hardline Iranian president Mahmoud Ahmadinejad will serve only to perpetuate fears about the country’s nuclear ambitions.

When one sets this against an equally assertive Israeli administration and a toughening of approach from the US towards Iran, it is easy to envisage deterioration in relations that may spook the oil markets: Iran is the fourth-largest producer and controls the strategically important Strait of Hormuz.

Monday’s statement by US vice-president Joe Biden that the country could not dictate what another nation could or could not do

met with an immediate response from Tehran that it would respond decisively to any Israeli attack on its facilities. Clearly, this issue will remain of interest to the markets over the summer.

A focus on the US gulf coast hurricane season will also be maintained since a large proportion of US oil supply is derived from the region. Forecasts suggest a quiet season, with half-a-dozen hurricanes expected. The likelihood of at least one of these systems making landfall remains high. Recent history tells us the impact of a destructive hurricane can prompt sharp price hikes: after Hurricane Katrina prices rose by $20 a barrel.

Prospects for oil prices are subject to a number of unpredictable influences. That said, it is hard to argue against a gradual rise in prices as the global economy emerges from one of the most severe downturns of modern times. The timing of such a recovery in prices is largely dependent upon the ability of financial institutions, governments and businesses to deliver the conditions in which sustainable expansion can be achieved.

Evidence is emerging that the worst is over and, while oil prices will continue to react to positive data, markets are unlikely to move higher in a straight line. Unpredictable events on weather and geopolitical fronts will ensure that upside risks to price remain in the ascendancy, with arrival at the Opec target range of $80 to $85 by the end of the year the most probable outcome.

Paul Harris is head of natural resources risk management at Bank of Ireland Global Markets