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The Price of Oil

The recent rise in crude oil prices has spurred the pundits to declare that we have reached a permanent plateau of higher oil prices. This week we will look at the data and see if it supports this view.

Anyone who has filled up the gas tank in their car this year has noticed the sharp rise in prices. Price per barrel of Brent crude is up 11% in the 4 weeks ending 7/23 and 37.5% over a year ago. The most recent price is just under $39 per barrel.

http://tonto.eia.doe.gov/oog/ftparea/wogirs/xls/psw13.xls

The futures market is suggesting that prices are going to continue to climb. As of 7/30, the futures price is $43.80 per barrel.

http://quotes.ino.com/

There are three causes for the rising oil prices. They are rising demand, lagging supply growth, and possibly an increased risk premium.

Rising Demand

A global economic recovery is underway. Demand for oil is rising with increased economic activity. Worldwide, crude oil demand is up +2.4% over the same period last year. In the U.S., demand is up +1.7% over last years. In China, demand is up a stunning +19% over last year. It's very likely that China will never again be a net exporter of oil.

http://www.eia.doe.gov/emeu/ipsr/t24.xls

Lagging Supply

Despite the rising demand, oil production has not kept pace. Measured on a year-over-year basis, world oil production was actually declining through much of 2001 and 2002. It wasn't until 2003 that production turned positive and remained positive. As of April, production is rising at +4.6% over a year ago.

http://tonto.eia.doe.gov/merquery/mer_data.asp?table=T11.01b

Globally, there have been production problems in Nigeria and Venezuela. Capital spending by energy companies has generally been flat to down.

http://www.thestate.com/mld/thestate/business/9284334.htm

Risk Premium

There may be an increased 'premium' priced into the price of oil due to uncertainty around the political stability of the oil states.

Saudi Arabia faces an active enemy since al qaeda has targeted Saudi and international oil workers and the House of Saud in general.

Despite the increased price of oil above OPEC's stated target price range, Saudi oil minister Ali Al Naimi says no need to increase production "The dollar is undervalued, the stock markets are a bit soft," "Investors are putting their money in other things, such as gold. There's lots of speculation, which is driving up (crude oil) prices."

Khaleej Times Article

There has been some speculation that Saudi oil production is already operating at capacity, and they couldn't significantly increase production even if they wanted to. It's difficult to judge the validity of these claims.

Economics 101

From an economic perspective, the market is working. Higher prices are acting as an incentive to producers to increase production. Higher cost wells can be opened and operated profitably at the higher oil price level. We see it in the statistics. The supply of oil is rising at a faster pace (+4.6%) that demand (+2.4%). Producers aren't just pumping more oil from existing wells, but opening new ones. The number of operating rigs is up 9% over the same period a year ago.

If supply continues to grow faster than demand, there should be lower oil prices in our future. The difficult call is the timing. If the higher prices we have today are a result of the supply reductions of 2001 and 2002, then it may be 2005 or 2006 before we see a sustained reduction in the price of oil.

Markets are smarter than people, so what is the market telling us? Even though the data (past information) tells us that supply is rising faster than demand, prices are rising. Perhaps the market is pricing in continued economic growth which will increase demand. Perhaps the market is pricing in continued problems with production. Venezuela's president faces a recall election later this summer. Political turmoil or further terrorism may disrupt oil supplies.

Oil and the Stock Market

It is possible that the price of oil has a modest effect on changes in stock prices. A quick review of the historical data since the mid 1980's shows that the percent change in oil price has a negative correlation (-0.22) with the percent change of the S&P 500 Index 12 months later. This means that when the price of oil goes up, stock prices sometimes go down. Of course, this does not mean that one necessarily causes the other. But the impact of oil prices affects nearly every aspect of the U.S. economy either directly or indirectly. It seems intuitive that the price of oil would have at least some impact on the market value of U.S. companies.

There are a few academic studies that support the theory that the price of oil has an impact on equity performance.

http://www.people.fas.harvard.edu/~pollet/papers/oilpaper_jmp.pdf

As of the end of Q2, our equity asset allocation target at Financial Methods remains very low at 30% of assets. Even though the rise in oil prices seems to be bad news for stocks, we don't see any reason to change our allocation target. We feel that we are already adequately protected.

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