Energy Sources: Oil spoils the show - Views on News from Equitymaster

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Energy Sources: Oil spoils the show

Sep 25, 2002

With global equity markets in doldrums and limited downside to interest rates, investors tend to put their money in commodities to ensure capital preservation. Among the commodities that has outperformed all others in 2002 year-to-date is crude oil. Prices of the natural resource have risen by 44% to $28.5/ barrel (Brent blend) during this period. Since our last oil market update in May '02, crude oil prices are higher by 10%. Prices have been on an ascent since the early part of the year. The rise had been triggered by twin effects of the Organisation of Petroleum Exporting Countries (OPEC) taking out 5 m barrel/ day (mbd) from oil markets since 2001 and the U.S economy -- the largest oil consumer -- registering first quarter GDP growth of above 5%. Adding to supply constraints, non-OPEC producers, in consultation with OPEC, agreed to pull out approximately 0.5 mbd of oil for the first half of 2002.

At the end of first quarter '02, changes in industry fundamentals were accompanied with Israel intensifying military action against Palestine. With geo-political tensions, oil markets built in war risk premium, as the warring communities are supported by heavyweight sympathisers. At the same time, U.S had commenced rhetoric of military action against Iraq, as the latter denied inspection of arms to U.N officials.

However, concern on the U.S economy and global economic growth rates has led to weakening in commodity prices over the past six months. But oil prices started to strengthen once again post June '02, as U.S considerably increased the threat of taking action (even unilateral) against Iraq. Despite Iraq agreeing to the U.N resolution to permit inspection of ordinance factories, U.S is now pressing for a new set of conditions, which has once again set off nervousness in oil markets. Without making public the degree of circumvention of U.N resolution by Iraq, the approach by U.S is not achieving consensus amongst the international community.

The OPEC, in their meeting last week at Osaka -- Japan, has decided to continue with the current production rates, as they believe global economic growth rates are likely to remain anemic for rest of the year. The higher oil price is largely a reflection of war risk premium built in by oil participants. That said, there is not much clarity on non-OPEC producers continuing with the production cuts. We reckon, prices are likely to remain firm in the mid-twenties, as the northern hemisphere moves into seasonally higher consuming winter months. But there is downside risk, if U.S and consequently global economic activity weakens in the coming months.

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