Friday, August 08, 2008

What price for oil?

Since last year Jamaica has been suffering under the pressure of escalating oil prices. Only last September oil futures were selling for less than US$80 per barrel (bbl). Less than one year later (July 2008) oil was selling for a record US$148/bbl, which is an increase of 85% in 11 months, rivaling any Cash plus returns. This week oil fell to below US$120/bbl and the world is breathing a sigh of relief. That’s amazing given that only last year it seemed ludicrous that oil would be trading over US$100/bbl.

The steep and rapid increase in oil prices has caused much economic hardship across the globe, as countries try desperately to cope with this essential ingredient of production and everyday life. Even rich countries such as the US have seen declines in real income levels, as consumers find it difficult to adjust to both rising energy and food prices.

Was there an oil bubble?
The recent fall off in oil prices have caused many to say that the rise in oil prices was a bubble waiting to burst, and sooner or later oil will fall to below US$80/bbl again. There are of course an equivalent amount of persons who believe that the recent fall off in prices is just a temporary reprieve in the inevitable climb of oil to even newer highs in the future. Even if oil falls off though, it is clear that we may never get back to US$30/bbl oil, and this means that countries like Jamaica must find more efficient means of energy.

These alternatives will of course include finding cheaper energy sources, and more importantly changing our consumption patterns, as it relates to energy. This however will necessitate infrastructural and cultural changes if we are to move forward. To compete internationally we will have to find cheaper energy inputs for production also.

The important question for the short term, however, is where will the price of oil end up? Is it that the run up in the price of oil was just a bubble that inevitably would have popped, or is this just a temporary ease, as consumers change their consumption patterns? The real issue still remains one of demand and supply in my view. Will there be an adequate supply of oil in the future to match the expected increased demand.

Before I look at where the price of oil will end up, I would like to briefly examine what are some of the underlying reasons for the recent fall off in the price. It is important to understand this if we are to determine what the future holds for oil prices. In March 2008, when oil was at US$105/bbl, I wrote that by April/May I expected oil to go above US$120/bbl. After that was achieved, on a radio interview I said that oil would spike to US$150/bbl and then drop off. The extent to which it fell off would depend on how quickly the price went to US$150/bbl, as if it gradually climbed there around November/December 2008 it would have continued rising. The fact that it went to US$148/bbl in July 2008 was good, as it meant that the fall off in price was going to be more violent.

The fact is the rapid rise in price to US$148/bbl in such a short period was unsustainable. What happened in more efficient markets, such as the US, is because prices moved up so quickly, income levels were unable to cope with the quick rise and so the reaction was to move to mass transit and cut down on discretionary driving. In addition the Olympics also helped, as in trying to clean up the air pollution China mandated that half of the cars usually on the roads, would have to be parked each day leading up to the Olympics. Also during August many traders usually go on vacation. The fact therefore is that the fall off in oil price was as a result of reduced demand globally.

Technical analysis
From a technical point of view, the chart shows the long term movement of the price of oil. It clearly shows that the long term trend of oil is still bullish; meaning over the long term it still seems set to rise. In addition the bottom chart shows that the declining price is losing momentum.

What this means is that the threat of rising oil prices is still very much present. Oil could very well hit the trend line support between US$110/bbl to US$120/bbl and bounce back up to the highs or beyond. This would signify a sharper increase than if it hits the longer term trend line support between US$100/bbl to US$110/bbl, which would mean a more gradual price increase. If oil fails to take out the high on any bounce this would be a good sign.

In order for oil to settle at US$80/bbl or below it needs to close below US$90/bbl. Only then would there be any hope for the threat of rising oil prices receding. Even the shorter term chart is showing that at the current price (approximately US$120/bbl) it is showing that oil is oversold and it could easily bounce back if some buyers started to enter the market.

In my view then, even though oil prices have fallen off significantly there is still no fundamental change in longer term factors that will definitely keep the prices down. The following factors may still continue to place wind behind the wings of oil prices:
-The US economy still shows uncertainty that can continue to cause US$ weakness. I expect this uncertainty will continue until at least the end of the third quarter;
-After August traders will come from vacation and could add to the market demand for oil futures (or could increase the down momentum);
-After the Olympics the full complement of cars may get back on the roads in China. And if the US economy starts to show some strength, going into the 4th quarter, then people could start driving more and taking vacations again. Additionally, the longer term demand could drive speculation that demand will outstrip supply;
-Iran does not seem serious about disbanding their nuclear program, and this could lead to increased geo-political concerns about supply; and
-The technical analysis shows that oil price could be well supported between US$100/bbl to US$120/bbl.

The irony is that world economic weakness is actually a help to reduced oil prices, as demand for oil will be lessened. What is clear though is that for the foreseeable future oil will still remain relatively high, when compared to former years, and will still be a significant burden for countries like Jamaica. If we do not act in the short to medium term to address our energy costs then we will become less competitive in a declining world economy, which is double grief.

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