EconoMonitor

The Kapali Carsi

What’s Driving the Rise in Oil Prices?

The price of Brent Crude, the benchmark based on North Sea oil, fell $ 35 between April and June, but increases since then have taken about $ 25 of that back. According to many, reports that Israel will bomb Iran’s nuclear facilities are behind this surge. But do markets believe that this event is now more likely to occur?

Here’s the intro. to my latest Hurriyet Daily News (HDN) column. I first show that geopolitical risks cannot be driving oil prices. Then, I go on to show that supply shocks are not fully behind the recent surge, either. That leaves more “economic”, or rather “data-driven” factors.  I don’t want to give away too much, but you can read the whole thing at the HDN website.

One thing I don’t do in the column is tell you my thoughts on where oil prices are headed. I will expand on the different factors I explain in the column to do that:

Geopolitical Risks: If my argument is right, the airstrike is not fully priced yet- which means oil will just lift off is Israel bombs Iran.

Supply Factors: There are many more issues than the ones I mentioned in the column. For one thing, if the Tropical Storm Isaac hits in full force, it could halt the 3 million barrels/ day production in the region, as a friend recently noted. There is also the question whether Obama will try to reduce gas prices by using U.S. strategic reserves before the elections. For that, looking at former elections may provide a clue. And if you’d like to move past these short-run concerns, a paper last month was arguing that supply was growing faster than demand. Econbrowser discusses that paper; there are also links to others that offer their take on the matter.

Economic Conditions: While James Hamilton argues that economic prospects in the U.S. are better, those in China are not, as the latest PMI hints. My same oil expert friend noted that a hard landing in China is not priced. As for QE, almost everyone agrees it is now almost a sure thing, with Morgan Stanley analysts giving it a 70 percent probability in their latest rates strategy note. Even fund flows are bracing for QE3: Gold and high yields are getting the most flows, as fund monitor EPFR noted today. The Congressional Budget Office itself has increased its income expectations from the Fed, which has led some to speculate that this revision reflects the extra income from QE3.  But my favorite Fed watcher argues that QE3 will be data-driven. For example, it has been underlined that these minutes have been written before the most recent non-farm payrolls and retail sales figures, which were both better than expected. The bottom line is that if QE3 doesn’t materialize, there is likely to be a negative effect on oil prices. BTW, if you want a more detailed expose of how QE3 would feed into oil prices, a recent column in Zawya does just that.

There are also a couple of issues that I did not mention in the column. For one thing, if the dollar depreciates  as a result of QE3, oil prices will reflect that as well. Then, there is what people call “technical factors”, which I don’t get into, as technical analysis is not my cup of tea. Finally, the same friend I referred to above noted that almost no one looks into how much oil is in the supertankers. You may wonder, if you are as ignorant as I was,  if the oil in a ship or two would make such a difference. It turns out, as another friend notes, that each of these supertankers carries about 3.2mn barrels of oil, amounting to 2-2.2 billion barrels per year, and there a few dozen of those…

What is the bottom line? It is tough to say how all these different factors will play out and what the overall result will be, but if you are aware of all of these, you can follow the developments in each of them and make up your own mind on the direction of oil. Having said that, I should note that many analysts are now expecting a pullback in Brent Crude prices, but don’t forget that a single event like the airstrike could reverse this picture in a day. Finally, I noticed, during my research for the column, that The Economist has tagged all its articles on oil prices.

Coming back to the column, one point I mention there is the growing wedge between Brent and WTI. My blog host Roubini Global Economics took on the issue some time ago, and Pragmatic Capitalism argues at least part of the risk is because of geopolitical concerns. Similarly, Turkish economist Atilla Yesilada noted that the recent pullback in the Brent-WTI spread reflects that geopolitical risks are not full priced. So you may use the spread as a measure of that, but note that it is affected by other factors as well, most notably relatively supply gluts and shortages.

It is also appropriate to say a couple of things about prediction markets. First, on why I like them a lot: A journalist writing an article on oil prices would get quotes from a commodity trader. But these guys may be reflecting their personal views or even “talking positions”, and so I prefer to trust the combined wisdom of markets. But having said that, prediction markets are not foolproof, either. For one thing, they may suffer from liquidity issues. Or if a trader is short-oil, she may buy the airstrike contract to hedge herself- in which case her move in prediction markets would not reflect her actual beliefs. But prediction markets are definitely useful, and in my case, my oil expert friend also confirmed, as I noted above, that markets are not fully pricing an airstrike against Iran.

Finally, this has been yet another long addendum/post, and so as in last week, I should provide some entertainment if you made it this far: The original title of the column was “Oil-boy wannabe writes about oil”, and the original introductory paragraph was something like this:

Ever since I watched Dumb and Dumber, my dream job has been to become an oil boy on the Hawaiian Tropic Bikini Tour. Since there were no openings the last time I checked, I will write about the commodity known as black gold instead.

As I mentioned before, my columns are published in the hard-copy of HDN as well, and so I have to stick to strict character guidelines- 3200 to be exact. And so I had to drop this wonderful intro. when I ran out of space:).

Let me conclude by mentioning that Turkey’s entry to the 1980 Eurovision contest was Petrol, which is the Turkish word for oil- a song that reflects on the oil shock in the years before. Unfortunately, no one likes to remember the bad past, and it wasn’t a good song anyway, and so it became fourth from last. Johnny Logan won that year with What’s Another Year

2 Responses to “What’s Driving the Rise in Oil Prices?”

adsanalyticsAugust 27th, 2012 at 5:36 pm

One factor driving commodity (and other risky asset) prices higher is excess liquitiy. One indicator (after the jump) is at the highest level in 15 years. Arguably, the Fed is being inconsistent (and committing the same mistake as Greenspan) focusing on goods inflation while ignoring financial asset inflation. This dynamic is really a sign of moribund economic activity – if the money is going back into the market rather than going into productive business investments.
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J.S.

Aegean1972August 28th, 2012 at 6:54 am

US and EU growth cannot materialize (in the long term) with oil prices the way they are.
Either oil prices will drop (at least 50%) of what they are now, or oil will be one of the key factors why consumer consumption will stay at rock bottom numbers.

US are you listening? You have the power to control this. Doing so can only help to our way back to growth.