High Oil Prices: Structural or Cyclical?

The international petroleum industry has intuitively recognized that cheap oil might just be a thing of the past. Now, producers and consumers alike wonder how high will prices go and most importantly how long will they stay there. Recently, a BP pipeline closing coupled with a foiled terrorist plan in London pushed oil prices to new highs as markets immediately responded to both events. But amid the myriad of drivers pushing prices up, which ones are cyclical or structural?

When thinking of oil prices, there are basically two schools of thoughts emerging. The cyclical school explanation argues that whatever goes up must come down. But, if you believe the structural school whatever goes up will stay up for quite a bit of time. Here, let us consider which drivers are the strongest to determine which school is right and in so doing provide a logical explanation to the industry’s intuition.

Dating back to October 2004, oil prices have gone from US $45 to about US $78 in August 2006. This marks a 57.6% increase in less than two years with Light sweet crude for September delivery rising to $74.70 in electronic trading on the New York Mercantile Exchange. Undeniably, such high prices are detrimental not only to consuming nations but to producing countries as well. In the long run, high oil prices have always motivated the investments in alternative energy sources which prevents producing nations from high and steady revenue sources.

But, should western nations really fear a repetition of the 1973 and 1979 oil crisis? Surely, an increase in oil prices has a negative impact on the world growth economy but nations are no longer as dependent as they were during the previous oil shocks simply because the damage base has been greatly reduced.
In the wet barrel market, three cyclical elements account for the 2004 increase in oil prices. First, an exceptionally strong demand in 2004 at 2.5MBD marks the highest growth since 1978. Second, the world’s economic growth and particularly China’s added to a very disappointing non-OPEC oil supply helped push prices up.

Outside Russia, for example, growth in production was only at 0.4MBD. Finally, geo-politics with events surrounding strikes in Venezuela, War in Irak, civil unrest leading to supply disruptions in Nigeria, standoff between the United Nations and Iran over the nuclear program of OPEC’s No.2 oil producer, the Lebanon-Isrealis war, BP pipeline issue and a recent terrorist plot in London. And with a spare capacity production at a sluggish 1MBD, all of these make for a very unstable supply chain which directly impacts oil prices.

In the paper barrel market, low inventories are seen as a signal of shortage. The first quarter total us stocks were at the lowest point since 1999 in 2004. Geopolitics, the second factor, further amplifies the fear of shortage with the Middle East being so unstable. Not to be taken lightly is the psychological aspect of high US gasoline prices supporting high crude prices.



   

At the structural level, chronic under-investments at all stages of the value chain have resulted in refineries being forced to run at nameplate capacities and above. Applying the simple economic law of supply and demand suggests that high oil prices indicate that oil might be running out.

The issue here is not the lack of oil reserves. Rather, the difficulty in producing, refining and bringing it to the markets. The necessary investments have not been made by International Oil Companies mainly because they choose to return funds to their shareholders instead of striking the right balance between investment and distribution. Furthermore, forward curves and spread trading practices indicate the structural change taking place in the petroleum industry. But International Oil Companies should not get the blame alone for lack of investments. Fiscal regimes around the world have changed not only the way IOCs invest upstream but also modified National Oil Companies’ access to funds. Clearly, structural elements are stronger than cyclical ones which explains why prices have remained at such a high level.

Traders and markets have become extremely nervous due to the low level of spare capacity. There is little doubt that had the spare capacity been at its mid 2002 level-roughly 7MBD, prices would not have reached such record highs. Unless the right investments are made quickly so that the spare capacity can be increased, oil prices will continue to increase and respond to events around the world.

Aimé Emmanuel Yoka

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