With oil prices reaching a two year high, has the oil market re-entered a period of instability?

Press release
Published December 26th, 2010 - 04:06 GMT
Badr Jafar, Executive Director of Crescent Petroleum
Badr Jafar, Executive Director of Crescent Petroleum

Over the last year oil prices have experienced a price stability not seen in years, but with the US policy of quantitative easing, this 'new normal' may now be under threat. Badr Jafar, Executive Director of Crescent Petroleum, explains the potential consequences of this for the economies and oil industries of the Middle East and why pursuing gas may be the best response to these challenges.

Since the latter half of 2009 the oil price has traded in a range of between $65 and $85 per barrel, a remarkably sustained period of stability compared to the prior period from early 2007 to mid-2009 when the oil price doubled, then quartered, before finally doubling again. The Majors' oil trading desks, independent oil trading houses and the oil trading desks of the major financial institutions are all believed to be considering scaling back their operations due to this lower volatility: most publicly the UK-based oil major BP recently decided to scale back its oil trading unit for precisely this reason.

"The price range established over the last one and a half years has suited both key producers and consumers groups" says Badr Jafar. "When oil prices were moving around unpredictably between 2007 and 2009 these two groups' relationship was very adversarial and industry investment suffered as a result. No one can plan investment for the long term surrounded by such uncertainty. But with prices stable around $70-80 per barrel, oil resource rich countries can confidently invest in upstream production, knowing that they will be profitable, and invest in projects to diversify and grow their economies, knowing that oil revenues will not collapse. Saudi Arabia's senior officials have confirmed as much on several occasions, saying that oil prices of around $70-80 per bbl are acceptable to it. Meanwhile oil consuming nations can feel confident that oil prices below $80 per bbl are compatible with sustained economic growth, which the OECD energy watchdog, the International Energy Agency, has confirmed in its public pronouncements."

"However, with oil price recently rising over $85 per barrel and towards $90 per barrel, oil prices are moving both above both their previous range and above the previously announced comfort zone prices of producers and consumers. I believe this rise may signal that oil prices are breaking out of their historic range, as they did in 2007 when they broke above c. $60-70 per bbl and that a similar period of price instability may be upon us." Jafar says.

Determining the impact of the recent rise in oil prices is very dependent on whether the rise has largely been in real or nominal terms. A real rise in the cost of oil may be much more significant to the world economy than a nominal rise. Certainly the growth in demand in the World's emerging markets suggests that rise might be due to supply and demand fundamentals pushing up the real price of oil. For example, Chinese oil demand is up 8.3% so far this year, adding 0.7 million barrels per day to global demand according to the IEA.

Yet the recent action of the US Federal Reserve to pursue a second round of quantitative easing (QEII) and its impact on asset prices and the value of the dollar may also be an important reason for the recent price rise. Such an impact would be almost entirely on nominal rather than real prices. Virtually all real assets have risen sharply since QEII became likely, even Western equity markets in countries struggling for growth, suggesting that the debasement of the dollar has pushed up nominal prices, rather than real prices across a broad range of assets around the world.

Since the head of the Federal Reserve Ben Bernanke indicated that QEII was a possibility in August 2010, the US dollar index, which tracks the US dollar exchange rate against other major currencies, has fallen 5.8%, meanwhile the price of oil has risen 12.6% over the same period in nominal terms. As oil is priced in dollars this currency debasement means that oil prices have arguably risen by a more modest 6.1% in real terms. So for the moment it appears that the oil price rise has been due to a mixture of real and nominal price pressures.

Even if oil prices have risen at least in part due to the debasement of the value of the dollar the rising nominal price of oil is likely to have a material impact on market incentives and behaviour. Most immediately the pressure for producers to increase production is likely to rise. In particular, OPEC members, who hold the world's spare oil productive capacity, may decide to increase their quotas. But this could be a gamble if it turns out that price increases are not driven by real fundamentals but by the stretching of nominal prices. Therefore, it is not a straightforward decision for OPEC to make.

However, there is another way for major oil resource holders in general, and the Middle East in particular, to take advantage of higher prices while protecting their economic competitiveness should such rises prove illusory: by increasing high value oil exports and reducing low value subsidised domestic oil sales through gasification.

Pushing for gasification will ensure that the region's maximises its economic competitiveness. While oil prices have risen of late the one global commodity whose price has not risen materially is natural gas. US prices have remained low as have prices in Europe and the Middle East's substantial indigenous gas resources position it well to maintain long term affordable supplies of the fuel. The scope for substituting oil for gas in the Middle East region is still substantial. On average the Gulf Cooperation Council members still sourced 40% of their electricity from oil in 2008, consuming c. 0.6 million barrels of oil per day. In the OECD the figure was c. 3.5% in 2008, with gas having displaced much of the oil used in power generation since the 1970s.

"The best way for the Middle East to fortify its economic position in the face of increasing oil price uncertainty is to continue diversification towards other fuels and gas is the most natural option given the region's considerable potential" says Badr Jafar. "Of course finding and developing upstream and midstream natural gas opportunities will be critical to delivering this greater security. At Crescent Petroleum we pioneered the gas business in the region with the very first two cross-border gas pipeline projects in the mid 80's, and we are now very active in both upstream and midstream gas in the region and feel well placed to be at the forefront of this process." 

Background Information

Crescent Petroleum

Crescent Petroleum has been operating as a regional upstream oil and gas company in the United Arab Emirates for almost forty years. 

Crescent Petroleum began its activities in the early 1970's and was the first regional, independent, privately-owned Middle Eastern petroleum company to engage in the acquisition, exploration and development of petroleum concessions; and the production and sale of crude oil, petroleum products and natural gas.

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