Will oil prices go crazy again?

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Since last summer’s high of $147 a barrel and its collapse to $40 in January 2009, oil has been slowly creeping up in price  – it’s $60 in early July. Should it go back on our agenda?

Oil prices are volatile for three reasons. First off, the spot price of oil reflects the gap between the immediate demand and the stock available. The future’s price of oil reflects the news and the amount of oil speculation. £130BN was invested by speculators in the oil market in 2007. By March 2008 this had ballooned to $260BN, as the oil market offered better returns than equities. Naturally, if the speculators are pushing up the short-term future value of oil, we all pay for it at the pump. One expert estimated that, speculative investment almost doubled the cost of a barrel of oil in 2008. At the moment the future oil price is between $70 to $80 per barrel. So the price is very likely to rise.

Second, is the match between supply and demand. To be frank, OPEC, the worlds largest producer tries to manipulate production to achieve it’s target price—around $60 – $70 a barrel. Saudi Arabia  is as worried about security of demand as much as the USA worries over security of supply.

Third, the costs of exploration and extraction are going up. Taking oil from tar sands is costlier than pumping it directly. If the world wants more oli from a more diverse range of sources, consumers have to pay the costs.

Although  these factors  were pushing oil to dizzy heights in the first half of 2008, they were overwhelmed by the global recession in the second half and the price fell sharply.

So why is the price going back up now? Three reasons: OPEC, the speculators and UK/US Exchange Rates.

OPEC’s response  to the price fall – with a 70% success rate  – was steep production cuts of 3MN to 4MN barrels a day. Since late May they have achieved their target price of $60+ per barrel.

The second is that cash flooded back into the oil futures market because it ‘contangoed’ in January 2009. In other words the value of oil in the future was higher than the spot price of all in January. Investors flooded in to buy physical oil and store it in tankers at sea while at the same time selling oil futures. As long as the value of the future oil was higher than the price they paid plus the cost of carry, they couldn’t lose.

Thirdly, the UK fuel price reflects the falling exchange rate  – see graph below. The red line shows that a barrel of oil dropped in profit potential between Sept 08 and April 09. The blue line shows the price of a barrel of oil in GB£. The UK should brace itself for a petrol price hike if the £ rises.

The link between UK Retail Fuel Prices and the £/$ Exchange rate

The link between UK Retail Fuel Prices and the £/$ Exchange rate

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