A colleague in Saudi Arabia and I have begun a six-month study of world oil prices in the hope of building an economic model that will produce more accurate forecasts of future prices.
Oil prices have fluctuated massively recently, from about $30 to $145, and no one has been able to predict them accurately nor explain sensibly the reasons for the past fluctuations. The level of world oil prices is very important for the oil&gas industry in Scotland for two distinct reasons.
Firstly, it determines what new fields in the North Sea will be developed and also when existing ones will be decommissioned. Secondly, it has similar impacts on worldwide oil developments, which are becoming increasingly important for Scottish-based companies, as I highlighted in this column last month.
UKCS activity is increasingly sensitive to price because of rising costs. The trend is for smaller and more remote discoveries, such as West of Shetland, and that normally implies higher development and operating costs.
World prices have been relatively stable of late, at about $70 per barrel. I believe that most people in the industry – producers, consumers and the supply chain – would welcome a long period of price stability. I hope we are in that now, and $70 seems to be acceptable to most members of Opec.
I have found it very difficult to understand the reasons for recent price fluctuations and, in particular, why they jumped to $145. I have read various academic studies and a recent report by the International Energy Agency (IEA) on price formation, but have not been convinced by their conclusions. The key task, in my opinion, is to separate the fundamentals of oil demand and supply from other factors, such as the activities of speculators and other oil traders.
The price of any commodity should depend on demand and supply. In the oil industry, those change relatively slowly if we look at them from the worldwide perspective. There will inevitably be changes from industry to industry and country to country but, when they are aggregated, they are usually long-term and explicable.
The recent price fluctuations are at variance with this view. I have long been puzzled by the oil market’s short-termism responses to minor supply disruptions, such as in Nigeria (fighting) and the Gulf of Mexico (hurricanes). The market frequently overreacts in the form of unjustified price rises.
The market for “paper” barrels of oil is now many times greater than the market for physical barrels. The speculators have been widely blamed for the rise to $145 last year and the increasing volatility among prices.
Traders or speculators can be divided into two groups. Firstly, there are those at the oil companies, refineries and industrial consumers, such as airlines, who need to take medium or long-term views and hedge on prices. Secondly, there are index funds and passive investors, plus hedge funds and traders who, in my opinion, seem to be betting on prices in a similar way to my gambling a few pounds on the football results each Saturday. This group has grown rapidly and is clearly the cause of much of the volatility. Let me give on example. A lot of the trading is in futures prices. When they are above the current, spot rises, it is known as a contango condition. At the time of writing, futures were about $5 above spot prices, but in January, they had reached an all-time high of nearly $24.
A clear reaction to that large differential was for producers to increase supply in order to put it into storage, particularly floating storage. In April, there were an estimated 120million barrels in floating storage, with 56 tankers involved, compared with the usual five to seven.
The relationship between spot and futures prices is not clear, nor the relationship with physical demand and supply. It seems to me that the evidence against the speculators is much stronger than stated in the IEA report and academic papers. I hope that if the industry can achieve and maintain a period of relative stability – presumably in the $60-80 range – a lot of the speculators will leave the market and turn their attentions elsewhere. Firmer action by the regulators allegedly responsible for the City of London and elsewhere would obviously help, although there is little sign of that yet.
Meanwhile, I’ll continue betting a few pounds on Inverness Caledonian Thistle on Saturdays. It has been a bad season for me so far.
Tony Mackay is MD of economists Mackay Consultants
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