Oil Update April 2008

Overview of the industry:

Oil is the most traded and most widely used commodity in the world at present. Not only is it used for the production of petrol, diesel and other fuels but it is used in the production of plastics, fertilisers, detergents and non-natural rubbers. Oil is indispensable to the industrialisation and development of any country and as of yet no suitable substitutes have been discovered. The burning of fossil fuels such as oil has been identified as the largest contributor to the problem of global warming. However in the short and medium term this is unlikely to dissuade a world faced with the choice between production at an environmental cost or no production at all.

The Organization of the Petroleum Exporting Countries (OPEC) produces around 41% of the world’s oil and accounts for more than two thirds of the world’s reserves. Over previous years this control of oil has given the OPEC countries considerable political influence in world events. Recently more and more wells are being drilled in non-OPEC countries, in order to circumvent their influence as well as to alleviate concerns over the lack of spare capacity in among the OPEC nations and take advantage of high oil prices creating incentives for exploration.

Oil is bracketed into three major types; West Texas Intermediate, Brent Crude and Dubai Crude. Of the three, WTI is currently used as the benchmark for world oil prices despite being temporarily superseded by Brent when a refinery closed in Cushing Oklahoma creating an oversupply in WTI on 13th April 2007 and artificially depressing the price.

There are currently several serious issues with the world oil industry. Pollution from oil is becoming a serious issue that needs to be tackled, demand is constantly increasing and recently has been driven by the growth of the Chinese and Indian economies. OPEC countries have very limited extra production capacity to meet this demand and the Hubbert Peak Theory concludes that we are at or near the peak world oil output, after which prices will spiral upwards as supply falls.

Global Demand:

World demand for oil is currently increasing at a rate of between 2-3% per annum and demand is highly inelastic; the recent price rises have done little to extinguish demand and the increased cost has simply been displaced to more elastic consumer goods.

Oil is used extensively in the generation of electrical power as well as for use in combustion engines. Even if all automobiles were powered by electricity, a large proportion of that electricity would have been generated from oil. Whilst there are strong drives to increase the use of greener energy sources, it is predicted that oil will remain the largest source of energy in the foreseeable future. Below is a chart of the actual and predicted demand for different energy sources, clearly showing that oil and natural gas will be the leaders.

Source: International Energy Agency

The United States of America has been the world’s largest consumer of crude oil and petroleum for many years. However the USA, like many other developed nations, is experiencing slower levels of growth than the less developed countries of the world. The economic slowdown in the world’s largest oil consuming nation is likely to impact the price of oil in the near future.

However as yet there does not appear to be much evidence of this occurring, giving great weight to the idea that Oil has an inelastic or near inelastic price elasticity of demand; despite price rises people still need to purchase fuel.

The steady growth of developed economies as well as the rapid growth of the developing economies is raising oil demand higher and higher. Approximately 1/3 of the worlds population live in either China or India, countries that currently have very low per capita incomes but are experiencing rapid growth. This growth is raising the standard of living in the two countries and is giving the people greater disposable income. In China alone it is expected that by 2010 there will be more than 250m people with incomes greater than $29,630. These 250m or more people will want cars, clothes, and air conditioning. The cars run on petrol or diesel, the clothes are made from synthetic oil based fibers, the electric air conditioner could be powered by an oil burning power plant.

In India, the Tata Group has come up with a next generation cheap car which has been compared to Ford’s original model T. This car is expected to cost just $2,500 and the company aims to bring motoring to many millions of Indians that currently either do not own a form of transport or rely on smaller and more dangerous mopeds. ‘Its release comes as India's domestic car market is predicted to soar in the coming years on the back of the country's fast-growing economy and increased consumer wealth.’ Source: bbc.co.uk

Recent Movements:

Prices of Brent Crude have been rising rapidly since September last year. Brent Crude, the benchmark most often used for oil production in Europe, Africa and the Middle East breached the $100 per barrel mark in February this year. The $100 mark was a large psychological barrier but, despite this breach, the price has continued to rise into record territories. Over the past 12 months the price of oil has risen by 34%, 46% since January last year.

Source: tfc-charts.com

At the time of writing WTI was priced at around $101 per barrel and Brent Crude at $100 per barrel. This is down from an 11th March high of $109 for WTI and $105 for Brent Crude.

As many of the developed countries in the Northern Hemisphere enter into spring and summer a mix of factors come into play. It is likely that they will reduce their consumption of oil for use in heating or the provision of electricity for the same purpose. But equally the use of air-conditioning units increases, demanding more electricity. Historically oil prices start to rise again as summer approaches for what is known in the US as ‘driving season’.

To take advantage of these price movements some investors choose to invest in exchange traded funds (ETFs) such as the Energy Select Sector SPDR which contain the shares of many large oil industry related companies. Other investors prefer to carefully select companies on their own, choosing smaller companies that can provide larger levels of capital growth, or larger companies that can provide more long term growth to their portfolios. With the continued expansion of the oil industry and the ever rising demand it is likely that whichever method of investment is selected it can yield positive results.