The Oil Price: Fundamentals or Speculation? Part One

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The oil price has been relentlessly rising, widely seen as being driven by a mix of fundamentals such as Asian demand exceeding supply, and fear of supply disruption caused in particular by unrest in the Middle East. Some, such as Ed Morse (shortly to join Citigroup as global head of commodity research), see the price risk to the upside this year and next, listing three main factors in what he terms the new geopolitics of oil in an FT article.

Firstly, while the precarious profile of many oil producing nations is nothing new, exhibiting (as they so often do) young, rapidly growing populations with high levels of unemployment, often a large underprivileged underclass and aging autocratic leadership of dubious legitimacy, what is new is the sudden realization that said populations can do something about the status quo through social unrest. Explosive regime change has been a shock both inside and outside the countries concerned and is set to spread further with uncertain consequences.

Secondly, to counter the above, oil-producing countries are ramping up already generous social programs and subsidies to placate the masses. In Saudi Arabia, the authorities have announced two packages of spending equivalent to $125 billion, about 27 percent of last year’s gross domestic product, directly impacting what Saudi Arabia needs to earn from oil exports. Morse suggests the budgetary break-even price for Saudi Arabia has escalated by 30 percent to $88 per barrel, with similar impacts in other oil producers, according to a recent report from the Institute of International Finance. It is now an imperative for countries like Saudi Arabia to keep oil prices high, meaning they will be less willing to pump oil if prices were ever to drop back below $85-90 per barrel.

Thirdly, oil producers are consuming more and more of their production at home. In the same way as domestic natural gas consumption in some Gulf states has taken precedence over exports of LNG, oil demand is rising rapidly to feed fast-growing and power-hungry populations. One FT article reports that while Brent crude is flirting with $125 per barrel in Tripoli (and elsewhere in the Middle East), gas is $0.55 per gallon, reflecting the ludicrous extremes that many regimes will go to in order to stave off domestic discontent.

Michael Wittner, head of oil research at Société Générale in New York, put the Middle East geopolitical risk premium at around $15-$20 per barrel, suggesting the true price based on fundamentals should be around $100 per barrel.

(Continued in Part Two.)

–Stuart Burns

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