Expect Increased Oil Price Volatility in the Current Environment

RelevanceOil price movements are driven by the perception of traders and news flow in the market place. A number of factors on both the supply and demand sides are contributing to increased uncertainty and we can therefore expect increased oil price volatility over the coming months. This will present opportunities for: (a) traders in oil; (b) investors in small explorers (whose stock price performance is driven by exploration success); and (c) investors in alternative energy. Investors in the majors are likely to see a strong underpinning of their stock also (as much of the news flow will be generally supportive of oil prices). 

AnalysisSpot oil price movements are driven by the perceptions of traders in the market and by news flow. To understand why this is we need to address the factors that impact both supply and demand.

In the short term, significant new supplies of non-OPEC oil are almost impossible to bring on stream quickly (given the long lead times of new projects). Even OPEC, which does have capacity, finds it difficult (politically and technically) to access this capacity in the very short term. The result is a supply curve that is very inelastic in the short to medium term.

Similarly, the demand for physical oil is largely unchanged from day to day and any variations in demand are more likely on a seasonal (and predictable) basis. Demand for oil, therefore, is also very inelastic in the short term.

What can change (and frequently does) is news flow and perceptions in the market place about where supply and demand are heading. Thus, we have a trading community that is highly sensitive to new news. So, for example, if supplies are lost (e.g. during the Iraq conflict, shifting the supply curve to the left) and traders believe that they will have trouble accessing oil (shifting the demand curve to the right) the result will be a sudden and potentially dramatic spike in price, even though the physical demand for oil is largely unchanged.

Currently we have many sources of news flow which have the potential to shift perceptions leading to increased price volatility. These include:

On the supply side:

  • Uncertainty around the capacity of OPEC to deliver new supplies. This is compounded by the perceived reluctance of OPEC to publicly commit to significant increases in capacity (no doubt OPEC is still haunted by the failure of its capacity investments of the 1970s, as demanded by consuming nations which then proceeded to invest in gas/nuclear/energy saving, leading to an oil price drop in the mid 1980s).
  • Negative news flow surrounding the decline production in established areas (e.g. North Sea).
  • Delays to big non-OPEC projects (Chevron’s Tahiti is the latest in a long line of delayed projects).
  • Uncertainty surrounding the cost and feasibility of exploiting huge and non-traditional resources such a shale oil.
  • The perceived slowness of substitutes such as bio fuels to make an impact.
  • The political uncertainty surrounding major potential suppliers such as Iraq, Iran and Venezuela.

On the demand side:

  • the uncertainty around the sustainability of growth in the economies of the major developing countries (such as India and China).
  • the economic performance of the major consuming nations and whether they are headed into recession (as predicted by an inverted bond yield curve).
  • the rate of increase in demand of the major oil and gas producing nations, as they seek to grow domestic industries such as petrochemicals.

9 July 2007

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