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Crude oil: Reality or a bubble? - Views on News from Equitymaster
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Crude oil: Reality or a bubble?
May 27, 2008

Oil is boiling and people around globe are feeling the heat. What are the reasons behind this up surge in crude price? Oil players are citing various factors such as the weak dollar, U.S. inflation, institutional investor positions in oil and geopolitical concerns as reasons for the steep price rise in crude. Some people believe that speculation may be contributing to the most recent moves in oil prices on the back of larger allocation of their portfolio to commodity speculation by pension and hedge funds. For example CalPERS (The California Public Employees' Retirement System), a US based pension fund allocated 3% of its US$ 240 bn to the commodity market. This high price raises the question whether this price level is justified or it’s a bubble, which is created because of speculation or over reaction of people. Recent expectation of demand supply mismatch has resulted into an abnormal up trend in crude price. Let us look at some fundamental data to assess the situation. According to Energy Information Administration, US Dept. of Energy, “World oil consumption is projected to grow by 1.2 million barrels per day (bbl/d) in 2008. U.S. consumption of liquid fuels and other petroleum is expected to decline in 2008 by about 190,000 bbl/d as a result of the economic slowdown and high petroleum prices. After accounting for increased ethanol use, U.S. petroleum consumption is projected to fall by 330,000 bbl/d in 2008."

Currently US accounts for roughly 24% of global consumption and a US slowdown is likely to affect the global off take of crude. Moreover, the slowdown in US can have a trickle down impact on emerging economies from where the US sources a lot of its imports. In a slowdown, US wouldn't be buying as much, and that could in turn impact the consumption in emerging market. Some people believe that growing demand in China will be major driver, but if we look at china it currently consumes 9% of global oil (and will increase to 14% by 2020), which is much lower than the US share. The rising oil price will also put pressure in the emerging markets to cut their subsidies and pass on some of higher prices to the end customer, which will lead to demand destruction and that in turn will exert downward pressure on the oil prices.

  • Bubbly crude, boiling rice & more

    Let us look at the second fundamental i.e. inventory. According to EIA – "OECD commercial inventories at the end of the first quarter of 2008 stood at an estimated 2.54 billion barrels, 22 million barrels above the previous 5-year average level. OECD inventories recorded a seasonal decline during the first quarter of 2008 to roughly 0.3 million bbl/d, about 0.1 million bbl/d less than the average withdrawal rate during the first quarter. EIA’s projected balances suggest that total OECD commercial inventories likely will remain near average levels for the rest of the year". Clearly, it shows a high level of inventory as a cushion against possible supply disruption.

  • Dealing with high oil prices

    Going forward it seems that parabolic rise of oil price is unsustainable. The price can come down, as high price will itself reduce demand by shifting it towards energy efficient and new technologies such as wind, solar and nuclear power. In addition, normalisation in coal prices could eventually take some pressure off oil. Furthermore, high oil price may lead to further pressure by the international community to increase production by OPEC. The Fed also appears to have completed its easing cycle and now has to deal with surging inflation. As raw materials prices remain stubbornly high, that task will prove difficult without a drastic reduction in demand by halting the declining interest rate and subsequently increasing it.

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