Early oil price correction difficult to forecast
Undoubtedly, a significant factor pushing up oil prices has been the weakness of the US dollar. Funds have invested in oil (and other commodities denominated in dollars) as a hedge against the decline in the dollar and rising inflationary pressures. Higher oil prices have also served as a hedge against the falling dollar for the oil producing countries.
The dollar is unlikely to give much support to oil prices in the near term. Indeed, the euro could yet see fresh highs against the dollar in the coming weeks with a move through $1.60 and beyond quite likely. Over the longer term, though, we are a little more optimistic for the dollar.
There is scope for a modest dollar recovery in the second half of the year, assuming credit markets stabilise and the US economy starts to respond to monetary and fiscal stimulus, which would erode some of its influence on oil and other commodity prices.
Meanwhile, the oil price support from investment funds, which have sought a wide range of commodities as protection against global stock market weakness and volatility, is likely to continue as long as markets remain fixated with the problems associated with the global credit crunch.
Oil’s bull run since the start of last year has also been supported by a build up of net long speculative future positions and these positions point towards expectations of even higher oil prices. A large part of the current oil price support would thus appear to be due to factors outside the underlying supply/demand balance for oil itself.
However, the price is also being supported by supply side concerns which are outweighing lower demand estimates.
The International Energy Agency has revised its estimates for world demand growth in 2008 significantly lower, in large part due to the slower economic growth in the US.
World demand, though, remains driven by high demand from China and the Middle East, which should more than compensate for falling demand from the US.
While we anticipate the US economy will start to recover in the latter half of this year, the risks to oil demand would appear to be to the downside, not only in terms of a weaker US economy but also European growth.
However, while demand estimates have been trimmed substantially, this has not been sufficient to relieve growing supply side concerns. Non-OPEC production is growing by less than had been anticipated. Meanwhile, despite repeated urging from Western economies, OPEC members have given no indication that they intend to respond to current high oil prices by boosting output.
OPEC blames current high prices on the weak dollar, speculation and political factors and insists there is no supply shortfall. Any near-term disruption to supply, such as the current problems in Nigeria, only serves to highlight the long-term supply concerns and provides a further support to oil prices.
The strength of supports for the market makes it difficult to forecast an early oil price correction. Indeed, it is difficult to see what in the near term might act as the catalyst for such a move.
Thus, while the extent to which the oil price is being underpinned by the weakness of the dollar and speculative flows leaves it vulnerable to correction, in the near term the price could remain well supported and, indeed, could move higher from current elevated levels. However, as with any asset bubble, if and when the correction comes, it could be sharp and sudden.
John Beggs, chief economist, AIB Global Treasury
