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Has Oil Risen too Much too Fast? - Outside View by Asad Dossani

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Has Oil Risen too Much too Fast?
Mar 1, 2011

The previous week has seen crude oil jump on the back of political unrest in Libya. Brent crude touched $119 per barrel, a level not seen since oil had its big run in 2008. The financial press is once again concerned with high oil prices, and the effect of this on the global economy. Prices have risen very quickly - around 20% in a single week. Is such a rise justified?

The most recent reports suggest that oil production in Libya has fallen by 75%, and this represents a reduction of 1.2 million barrels per day. This is about 1% of daily oil consumption - an amount that is small but still significant. Obviously, we expect that a fall in oil production will lead to rising oil prices. But is a 20% rise in a single week a sensible reaction to a 1% fall in oil supply?

The answer is no if Libyan production is the only factor affecting the price. It is clear that markets are pricing in a potential larger fall in supply triggered by further unrest in the Middle East. Protests in Tunisia were followed by protests in Egypt, and now there are protests in Libya. The domino affect is apparent, so it is no surprise that markets are worried that another country's production could be affected. There are reports of protests across other Arab countries, and steps taken by various leaders to make reforms in their countries, as they fear popular uprising.

When crude prices reached close to $150 per barrel in 2008, it was all about demand. Investors were worried about a demand explosion from emerging economies, and this continued to push prices up. Of course, many Western countries were entering recession, and emerging market growth was slowing at this time. Crude subsequently corrected in the following year. What we know about oil demand is that it is more predictable and stable than oil supply. Oil demand is strongly correlated with GDP growth, which tends to be stable for most countries over time. Therefore, a large rise in prices that is based on expectations of soaring future demand is probably unsustainable. Demand will grow over time, but not in an explosive way.

Today's oil price rises are all about supply. The market may have already lost 1% of its daily supply, but this number could easily go up in the near future. The factors that determine supply in the short term are all political factors. This makes the price very volatile and unpredictable. Speculating on the oil prices is for now equivalent to betting on whether another revolution will occur in the Middle East.

Going back to the initial question, its probably true oil prices have gone up too much too fast, but this is on the assumption that no other countries' oil supplies are affected. As oil prices are heavily dependent on political factors in the short-term, the price movements are volatile difficult to predict. For investors, it is probably wise to stay out of this market until things calm down a bit.

Disclosure: I do not hold the currency/commodity viewed/opined in this column

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

Disclaimer:

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