Posted in Finance Articles, Total Reads: 1405
, Published on 04 January 2013
The Oil shock of 2012 is a great source of concern considering the crude oil price escalation and volatility observed in this year till now. The price movement is increasingly seen decoupled from global oil demand begging the question as to which asset class does Oil belong to. This article has explored the structural changes that has modified the nature of oil and made into an investment class product. It also explores how countries should manage uncertainty revolving around oil prices and reflect upon the future trends expected regarding the “black gold”.
Oil prices were high during much of the first quarter of 2012 but the price trend reversed and saw steep fall in April, going on to slide substantially in May and June. This fall in prices is believed to be due to concerns that opposition parties would win the national election in Greece. Such a result would not only lead to the country de-faulting on its national debt obligations but also quitting the European Union. At the same time, trends from India and China, key growth markets for oil demand, showed slowdown suggesting a lower future global oil demand.
The falling oil prices trend was reversed soon after the Greek election, when the government parties won. Since then oil prices have consistently increased, apart from minor corrections, even though there has been a stream of negative economic data news and the Euro zone debt crisis has lingered on.
But this volatility and price trend have led to the question as to which asset class should oil be relegated to. Oil has historically been viewed as a pure commodity with price closely related to supply and demand forces. The demand for oil has been fairly consistent, increasing at a growth rate of 1.2% every year with changes in supply structure leading to pricing variations. High crude oil price led to more suppliers entering the market leading to price fall while low crude oil price led to suppliers easing production levels to check falling prices. But lately, the price trends being observed no longer seem to fit this understanding. Crude oil prices spiked heavily in 2008 to reach an all-time high of USD 145 a barrel before seeing a deep crash with the recession. The prices rebounded later from Jan 2009 as the global equity markets and ASEAN economies emerged as growth drivers and spiked again in mid-2011. These high price fluctuations are observed even though we can observe the global demand for oil has not seen any wild swings.
Figure1: Oil Price over years
Figure 2: Global Oil Product Demand
Analysing figures 1 & 2, it is observed that from 1996-2006, oil price has a high co-relation to the global oil demand with both the charts showing consistent growths. But 2006 onwards fluctuations in the oil price cannot be explained by global oil demand. Especially in 2012, the high volatility observed in day-to-day prices is more an indication of an investment product rather than a commodity. Even, Organization of Petroleum Exporting Countries (OPEC) in its World Energy Outlook 2011 report stated that making assumptions for future oil price development is complicated by the dramatic price turbulence in 2008 – 2009, and the fact that this was not driven by fundamentals.
Advent of oil as an asset class, increasing change of government regulations and rise of renewable energy resources has distorted oil price’s high co-relation with global energy requirement.
Investment interest in commodities as an asset class has significantly increased since 2007. This is true for especially oil which is seen as one of the primary commodities like gold, iron etc. Earlier, the oil futures and over-the-counter (OTC) markets were dominated by large commercial organizations looking to use these instruments to hedge price risk. But lately, there has been increasing participation by financial organizations looking for higher returns from a rise of fall in oil price and/or simply looking to hold oil as a long-term investment option. US markets have even seen oil-dedicated investment products being launched like the United States Brent Oil Fund, an Exchange traded fund dedicated to investing in oil assets. This trend has been strengthened by the liberalization of regulations on commodity markets (US Commodity Modernization Act 2000) and a global low interest rate environment since the 2008 global crash.OPEC also in its World Outlook report states that growing involvement of investment banks and funds has provided opportunities to generate returns from the performance of oil derivatives (futures, options and swaps), and, as a result, oil has evolved with other commodities into an asset class.
Over the last 5 years, oil depletion and global warming have taken centre stage in the global political stage. As a result, Governments have also increased their focus on renewable energy eco-systems like wind energy, solar energy, hydro energy etc. through providing stimulus in the form of subsidies and/or investment funds to this sector. These developments have distorted the earlier direct connection a country’s energy requirement had with oil demand making it more difficult to understand and predict future oil demand.
Figure3: Falling Oil contribution in total world energy source
These 3 factors in combination distort the global oil demand curve leading to severe oil price volatility exacerbated by speculation money.As a result, it is believed that crude oil has shifted from a pure-play commodity to take the role of an investment product.
If the fears and tensions regarding Iran are put to rest, the prices in the short-term should come down to around $100. Also, if the dispute regarding the gas pipeline with South Sudan is settled soon, it will not only reduce the oil prices but also help ease the burden on the wide trade deficits and help the manufacturing activities. Though, the resurgent Middle East Gulf tensions don’t look likely to improve anytime in the near future.
In the long-term, it is much more difficult to predict prices due to the high volatility now in-built in the oil price curves. Emergence of EU from the debt crisis, global economic condition, breakthroughs in renewable energy sources, supply side disruptions etc. all can play a hand in shifting oil prices away from the price curves. Back in 2008, when the economies of most nations were struggling, the oil prices had crossed the $140 mark because the people had lost faith in any other forms of investment and resorted to investment in oil and gold. The economies are doing better than in 2008 and hence the markets sentiments are unlikely to drive the price of oil up. However, the demand for oil is likely to increase on recovery of the struggling economies and there is still a concern about the supply of oil because of tensions between the USA and Iran.
OPEC recently in its Long-term Strategy report solved the problem of creating a single future long-term demand by projecting global demand in 3 different scenarios.
PMT(Protracted market tightness) – This scenario will be observed if the struggling economies recover leading to high demand and the supply is still struggling owing to tensions between USA and Iran. This will lead to further increase in price.
PSM (Prolonged soft market)- This scenario is depicted by robust oil supply from other sources other than Iran enough to sustain the demand. This will result in lowering of oil prices to a certain extent.
DAU (Dynamics as usual)- This is a central reference scenario wherein the economies and oil supply both are robust leading to a gradual increase in oil prices.
As it can be observed in the below graph, PMT projects the highest demand increase due to a combination of demand side strength and supply side weakness. OPEC has stated it expects the market to initially follow the PMT scenario before correcting to DAU trend line over long-term.
Figure4: Projected Future Oil Demand
Conclusion & Future Directions
The steady increase in oil demand coupled with declining oil deposits, and various short-term volatility inducers will only lead to volatility in the future oil prices too. The paradigm in the near future would be to accept oil demand-supply and its price volatility as the writing on the wall and try to manage it effectively. The middle-east fears will also be a major governing factor in determining the future of oil prices. Corporations and nations should increasingly look to creating effective hedging strategies to better manage the inherent risk. A leaf from USA’s book can be taken that has over the last decade generated resilience by developing self-production facilities, strategic reserves, diversification of imports and other measures. The victory of tomorrow would go to the nation that can find the correct portfolio counter-weight.
This article has been authored by Aarti Gupta from FMS.
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