Why are oil prices rising?

When it comes to oil prices, much like any commodity price, the future is always uncertain and anyone who says they know what the future holds should be met with skepticism. Variables such as market traded prices are not extrapolations of the past.

However, it is a useful exercise to observe the current relative position of oil prices and delve into the factors contributing to it. We have seen oil prices hit approx. $75 per barrel in the last few weeks representing the highest prices since 2014. If you’re here in South Africa, the pinch is tingling right in your bank account and pocket at this very moment given that our regulated fuel prices are based on international product prices which are in turn linked to crude prices. This is even before we factor in the Rand/Dollar exchange rate impact on these quoted prices which also plays a significant part in the volatility of local fuel prices.

A decent starting point for viewing any price and its trend is the application of the simple laws of demand and supply. As such, when we hear about critical market input news and trends regarding key players i.e. OPEC members, Russia, US, China, India etc., it is always necessary to classify its impact under one of these categories of demand and supply in order to link it to how it interacts with the price outcome.

Below is a summary classifying impacts, with respect to demand and supply, that have found us at price levels last seen 4 years ago.

OIL SUPPLY FACTORS

It has tended to be that most of the action in price movements originates from supply influences particularly in recent history when world demand has been on a steady upward trend with global post 2009 economic growth. Below are the key supply factors at play currently:

OPEC & Russia Production cuts

As of January 2017, OPEC and Russia (who together account for about 55% of world production) agreed decreases in production. A motivation behind this was to drive down the high stock piles of the 2015/16 glut which in themselves where contributing to the low prices of that period. For Saudi Arabia, the de facto leader of OPEC, there are some additional incentives. These include how higher prices allow for improved capital raising when Saudi Aramco floats a private stake in 2018 or 2019 as well as overall better fiscal inflows given the economic reform agenda being pushed by Crown Prince Mohammad bin Salman. Another angle is the requirement of steady funding for war against close proximity Houthi rebels in neighboring Yemen.

Geoploitics

This is always an ever present supply factor given the geography of oil reserves - approx 80% of world oil reserves are in OPEC member countries with 65% of this 80% being located in the Middle East. The impact of geopolitics is amplified in combined high demand and deliberately reduced supply times such as these. The most glaring one at the moment is the geopolitical tension at play between the US and Iran.

The US is threatening pulling out of the 2015 Joint Comprehensive Plan of Action (JCPOA) nuclear non proliferation deal with Iran. The d-day for this is May 12th 2018 when the US have the opportunity to make a decision on extending the sanction waivers that came as part of the deal in return for Iranian compliance with the deal. This move could see sanctions re-imposed by the US on Iran, OPEC’s 3rd largest producer of oil and therefore broadly taking this oil off the trading market. It remains to be seen how pulling out of the deal by the US will exactly play out in terms of sanction effects and timing of such sanctions but the uncertainty is playing out in higher prices of oil. Iranian involvement in Syria on the flanks of the Assad regime as well as in Yemen on the Houthi rebel side only further complicates this tension.

Another big geopolitical situation is the crisis in OPEC member Venezuela. The economic meltdown evidenced by current inflation rates of 18 000% has meant oil production is at a 30 year low despite Venezuela having the largest proven reserves in the world. This means even though OPEC and Russia have been cutting production, Venezuela’s precarious socioeconomic situation has meant the joint OPEC cut effects on total supply have been intensified. This will likely remain so especially under the current demand-supply climate as long as Venezuela cannot get their OPEC mandated production online.

US Shale Boom

The growth in US Shale Oil and Gas production has been touted as a revolution over the last few years. Developments in hydraulic fracturing technology combined with steadily increasing oil prices have provided shale producers with the opportunity to bring increased US production online. The ability to bring already set up shale oil production online quickly means that it is relatively agile to responding to price movements. One therefore sees a relatively sensitive elasticity between prices and production levels compared to conventional oil production. This is particularly the case above breakeven price levels estimated by some at between $50 and $60 a barrel. One would expect then that this production increase/inventory build given current prices would therefore have the counter impact of dampening them. However, this is not what is reflecting as it would seem demand is absorbing this production and given current group oriented production cuts as well as geopolitical frailties, the additional supply impact is being masked.

OIL DEMAND FACTORS:

Demand factors relate to how much of oil is required for consumption by the world economy. These factors have tended to be more stable than supply however, are equally important in setting the tone of overall price direction. These include the following:

Rising Oil Demand

From 4Q2013 to current times, world oil demand has gone from about 93 million barrels per day to an estimate of about 99 mb/d according to the International Energy Association (IEA). This represents an almost 6% increase. China has been a major factor in this trend as it literally fuels its growth. Even as China gradually moves to a more services/tertiary industry oriented economy, India is ramping up its secondary industry intensity, i.e. manufacturing, potentially continuing this energy demand growth trend. China's secondary and tertiary industry as a proportion of GDP are estimated at 40% and 52% respectively while for India the same comparison is 31% and 54% indicating how India can grow into this secondary industry space .

Speculative Purchasing of Oil

Under the current turbulent geopolitical and post 2008 growing global economic environment, oil has provided a backdrop for increased speculative long positions from market participants e.g. traders and hedge funds. These long positions provide price support to increased oil prices though they do raise the risk of a price crash if these positions are settled and profits are cashed in.

In conclusion, there will also always be cross interaction of factors which further adds to the complexity that is the universe of oil prices and as observers, this is something we must contend with. As for the future, the age old saying perpetually applies – Only time will tell.

By Tare Kadzura ACMA CGMA EMME