From the 1970’s until 2004 the world has seen oil prices fluctuating but remaining under the $50 per barrel price level. However during 2004 especially in the fourth quarter we saw oil prices at record levels, seriously weakening the US dollar. Since then there seems to have been an increasing amount of reasons to sustain prices at such a high level.
The first main reason is due to the war in Iraq, because Iraq is a large oil-producing nation, the war has had a great affect on the barrel price. The main driving force is the so called ‘security premium’ that has been applied to production. Insurgents in Iraq are well aware of how much disruption they can cause by targeting oil supplies. Indeed many insurgents in Iraq have targeted pipelines and oil reserves reducing these oil supplies. Basic supply and demand dictates that (ceterus paribus) if supply is reduced and demands remains the same, prices will rise. This is exactly the situation we have seen. Such activity has meant occupying forces have had to protect pipelines and refineries as much as is possible, however due to how vast the length of some supply lines, this protection can prove a very difficult task. We saw a similar spike in oil prices when the first fighting broke out in the Iran-Iraq war in the early 1980’s and when Iraq invaded Kuwait in the early 1990’s. Heightening tension in Iran is not helping oil prices at the moment; as Iran is the fourth biggest global producer.
The recent wave of hurricanes to hit America; a large oil producer and a massive oil consumer, have served to compound rising prices. Indeed August 2005 saw highs of above $70 per barrel. Hurricane Katrina affected America badly, however hurricane Rita which followed, had a particular affect as output was seriously reduced because of the geographical location of the storm, being close to key US oil refineries. Again, the supply and demand principle referred to above comes into play. Then tropical storm Wilma raised fears as she too headed towards the Gulf of Mexico. The prospect of these storms wiping out the key natural resource or at best crippling production capacity forced the price per barrel of oil upwards.
Two key points are worthy to note in both cases mentioned above. Firstly the anticipation of an event is priced into markets and causes reaction before the event has occurred, often markets expect things to be worse than they actually are, bringing uncertainty which can be seen unwinding after an event has taken place. Secondly, despite stabilising attempts by bodies such as OPEC, which can lessen effects, supply and demand define the market place and are the deciding forces.
With the situation in Iraq getting no more stable than it was twelve months ago and the unpredictability of weather patterns the future for oil prices seems uncertain, and we all know the markets do not like uncertainty.
Nicholas Fullerton is a Senior Foreign Currency UK trader who has worked in the currency markets for many years now. He has vast knowledge of currency contracts such as spot and forwards and how economic and political factors shape the market!