Oil Prices - Where To From Here

"Behind every great fortune there is a crime." - Honore de Balzac

If ever there is a commodity that has its fair share or more of crimes it must be oil.  For the last few months oil prices have been spiralling higher from a low of around $74 a barrel in October to over $100 a barrel earlier this month.  As such it is time to have another look at the commodity that shapes much of the global economy and has a great impact on global growth.

Sometimes I have the misfortune of tuning in to a news cast of the day's market activities and I always have a laugh when I hear the analysts crowing over how high the price of oil has moved that day, or week, or for the year.  It is as if the upward movement in price is a good thing.  Well in all likelihood it is a good thing for the trader if he is long the position.  It is also a great thing if you are an oil producing nation, but what of the majority of countries that are oil importers?  Furthermore is this not a massive sign of impending inflation?

The problem with oil prices is that they are based on very poor data.  On the one side of the equation is the supply of oil.  How much oil is there available and how easily is it accessible?  These two questions are almost impossible to answer as most of the oil lies in fields that are governed by notoriously shady characters in parts of the world that are mired in violence and corruption.  Furthermore as technology advances and techniques for extraction improve, places that were once considered inaccessible are suddenly viable and wells that were thought to be dry can now be re-drilled and provide additional supply.  Finally it is never known exactly how much oil can be extracted from a given well even when the total supply is fairly well known.  Some wells dry up well before they were supposed to while others continue to produce for years after they were supposed to be depleted.  Adding all of this up to determine supply and adding to that an estimate of unfound reserves means that the amount of oil remaining is unknown.

The second problem is that while the oil may be accessible, it can be disrupted by a war or a coup.  As very little of the oil comes from economies that are considered "stable" in western eyes, there is a fear premium attached to the price of oil.

On the supply side things are a little more quantifiable.  A good and growing world economy would drain the supply of oil faster leading to an increase in the price of oil, however as the price creeps up so do the incentives to producing fuel efficient vehicles, machinery and equipment.  This can create a situation where less oil is used even while the economy expands.

So why in this poor of an economy is the price of oil going up so fast and does this point to inflation and an expanding economy?  With new fields being tapped in Brazil and others coming online in Canada and the United States it appears that there is more than sufficient supply to handle the current economy.  Furthermore it is my opinion that with the technological advances in extraction and seismology that we will find massive oil fields dotted all around the world that will become accessible.  It is also my contention that as the world turns "green" that consumers in developed economies will start to rely more and more on alternative energy sources and move away from the toxicity associated with oil burning options.  So that leaves the developing world.

To the developing world the cheapest option is the most viable.  That said the price of oil is rapidly becoming uncomfortably high again so I believe these economies will start to feel the pinch of high oil prices and will begin to reduce their consumption.  Furthermore the current state of the global economy does not warrant the current price of oil and these price levels will start to affect growth as more and more money of an already strapped consumer is swallowed up by the oil monsters.  As such the global economy will not be able to continue to support these price levels.

Looking forward I believe that the current price levels are unsustainable and are set to fall.  Weak global fundamentals and a burgeoning supply of oil from places like Brazil will put a lid on this move and will stave off any concerns that these price levels will start to move inflation.  On the flip side of this, if prices remain elevated for much longer then you will start to see a ratcheting down on economic growth rates as consumer spending will be impacted and company profits will become squeezed.

Oil companies have been a recent benefactor from the rise in the price of oil however their rise has not been in line with the price of oil as the share prices are under performing the commodity move.  Furthermore the chart of oil company stocks is looking decidedly weak.  So while this group of stocks has aided the stock market rise it signals a level of distrust for the recent commodity price rise.  Going forward if the price of oil falls to a more manageable level these benefactors will be levelled and will put a drag on the stock market advance.