3 Reasons Why Crude Oil Prices Will Stay High

by: Dennis U. Atuanya

Global crude oil prices have risen significantly since the beginning of the year, largely driven by the unrest in the Middle East and North Africa (MENA) region. Brent prices for example, rose by more than 21% between the beginning of the year and the end of March; but with the seeming adaptation by markets to the risks associated with the unrest, as well as the recent advice issued by Goldman Sachs to its clients to sell their investments in oil, investment decisions have focused on a possible crude oil price collapse and its implication for oil stocks.


The MENA unrest has undoubtedly added to recent global crude oil prices but it is worth noting that the latter were already on an upward trend since 2009 (See Figure 1 below), bolstered largely by strong emerging market demand in a rebounding (even if sluggish) global economy.

However, recent spikes such as the 30-month highs seen about a fortnight ago may reflect more of a risk premium than any fundamental tightening since there were, and currently are, no near-term shortfalls in supply projections. About the same period for example, Energy Intelligence reported that global crude oil production exceeded demand by about 500,000 barrels per day, bpd; and last week, the Saudi oil minister revealed that the country's crude oil production for the month of March fell by 833,000 bpd from February's production levels due to lower demand. Though the International Energy Agency, IEA, in its latest report held that growth in global oil consumption for 1Q'11 dropped to 2.6% from the 4.1% recorded in 4Q'10, that may be set to change; the second quarter typically sees an uptick in crude oil demand even as refineries return from maintenance.


That said, high crude oil prices boosted energy stocks during the first quarter of the year. The Energy sector at S&P for example, showed better than threefold return over the market average (See Figure 2 below).

(Click to enlarge)

Though there may be dips or corrections, crude oil prices would probably remain high and for three reasons:

First, emerging market demand has been a strong driver for oil prices in recent years and even when the economies of China and India declined in 2009, for example, their total petroleum consumption increased. Oil demand in many of the emerging economies is driven, in the main, by subsidies, which, given their rather low socio-political flashpoints, may not be removed anytime soon; and that raises fears of inflation. China, in an attempt to curb inflation, recently increased banks' reserve ratios by 50 basis points to 20.5% but only allowed domestic fuel prices to rise by a smaller rate (5%) than the rate of increase (14%) for its reference crude oil basket. These may not translate to any significant reduction in the country's oil consumption though the longer-term sustainability of these subsidies remains to be determined.

In spite of rising oil prices, the Asian Development Bank expects a growth in the region's economy, of 7.8% and 7.7% for 2011 and 2012 respectively. According to Financial Times, while European crude oil demand for February was largely flat, that for Asia was up 5.9% (China's up 9.6%) and that for the U.S. up 2.9% (possibly rising higher in the summer or driving months).

Secondly, despite pockets of problem zones, the global economy is seemingly set for growth, and with it crude oil demand, even if in the medium-term. The International Monetary Fund, IMF, in a recent report for example, expected global economic growth for 2011 to be 4.4%. In addition, the Organization for Economic Co-operation and Development estimated the annualized 1H'11 growth rate for its G7 member-countries (exclusive of Japan) to be 3%. However, a major oil price shock, especially if sustained, would most probably end all such growth prospects. Current crude oil price levels inevitably draw comparisons with the record values of 2008. Energy Information Administration data show that in 2008, average prices for Brent and West Texas Intermediate (WTI) crude oil grades were US$96.94 per barrel and US$99.64 per barrel respectively; for 1Q'11, the values were US$104.96 for Brent and US$93.54 for WTI.

Finally, quite a few members of the group, Organization of the Petroleum Exporting Countries, OPEC, have embarked on various elaborate short- to medium-term projects which require certain oil price levels to break even. Estimates for these levels range from US$79 per barrel to US$92 per barrel and would be significant factors in setting target crude oil prices. This is compounded by the group's rising domestic oil consumption profiles which, if sustained, would amount to between 35% and 40% of its total production in a little more than a decade. The consequent reduction in available export volumes would further tighten global supply, putting upward pressures on prices.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.