August 2008

Oil, why is the price so high?

The last twelve months has seen a dramatic rise in the price of oil, particularly in 2008, with the price more than doubling and reaching a record level of over $147 on 11th July. This has prompted the obvious question, why is the oil price so high?

The most obvious reason for the high price is an apparent mismatch between supply and demand. This has been largely attributed to the significant increase in global demand for oil and other commodities, especially from emerging markets and in particular, China, while the US remains the largest oil consumer.

On the other side, supply remains a major issue with most Opec (Organisation of Petroleum Exporting Countries) members appearing reluctant or unable to raise their output. Furthermore, non-Opec countries, including the UK, are seeing declining production.

Political problems can also have a significant impact on the supply of oil with the commodity often being found in volatile regions, which leads to fears over the stability of supply.

Another contributor to the rise in the oil price has been the weak US dollar. This weakness affects the oil price in a number of ways. Firstly, a weak US currency makes US dollar-denominated oil cheaper for non-US importers while secondly, investors are buying oil instead of the less attractive US dollar, thereby driving up the oil price.

A final potential reason for the high oil price is market speculation. Oil exporters believe that traders are making significant sums of money betting on the direction of the oil price and this in turn is driving the price higher. This is being investigated in the US to see whether there is any evidence of market manipulation.

Having looked at some of the reasons behind the rise in oil prices, what has been the impact of the cost of oil on the global economy? The most obvious impact has been the rapid increase in global inflation through higher energy and transport costs and this has been evidenced in the UK by the latest CPI rate for June of 3.8%, which is significantly above the target level of 2%.

A period of sustained high oil prices can also result in higher interest rates, which has been seen in selected regions already, and slower economic growth. If the price was to remain high for a longer period, it can also result in a recession.

In the week commencing 14th July, there have been growing concerns over the impact that slowing global economic growth will have on the demand for oil and this has resulted in a steep drop in the price to around $130 from the previous week's record high level. It is hoped that this sharp fall will reduce inflationary pressures.

However, there is still much caution about calling the top of the market as a number of the reasons for the rise remain in place.

For investors, the significant rise in the price of oil and other commodities has led to a massive increase in demand for funds that provide exposure to these assets.

However, investing in a single sector can be high risk and while the potential rewards can be high, as seen in recent years, any downturn in commodity prices could see significant losses as well.

At Origen, we agree that this asset class continues to have potential for gains, but unless the investor specifically wants to invest in this single sector, we prefer those funds that provide exposure not only to these particular stocks, but also offer diversification into other areas, such as other commodities/miners, agriculture and companies that service all these industries.

Richard Wallis
Deputy Head of Research and Investment
Origen