RIYADH, 16 August 2004 — Oil price has recently exceeded $45 a barrel, the highest in 21 years. Consequently business executives and investors have become nervous about possible severe supply shortage. With many worrisome activities taking place simultaneously, it is no surprise investors are fearful and markets are lurching violently.
Why it is up? The unrest in Iraq has intesified lately, and as a country with the second-largest oil reserves after Saudi Arabia, it carries a significant weight in the oil market. When officials recently shut down several oil fields in southern Iraq amid fighting and threats of sabotage, oil prices bounced. One big, destructive hit there and its likely prices would shoot further to a new high.
Other factors at work are Russian oil-company Yukos that had its bank accounts frozen and is on the verge of bankruptcy, which would force it to suspend operations. Its oil accounts for 20 percent of Russian oil exports - the world second largest producer. Another potentially inflammatory situation is the referendum to recall Venezuelan President Hugo Chavez in August. Venezuela is the world’s fifth largest oil producer, so any unrest there could clobber the market a little further. Terror threats on the US and Western Europe are also adding panic and unrest to the oil and financial markets. In addition to all the above supply constraints, global oil demand is increasing gradualy particularly that of China.
Significance of Oil: Basically it is all related to critical human needs namely water, food, shelter and security. An individual or a country will get extremely worried, and might turn aggressive, if it is deprived from any of its critical needs. In fact oil plays an important role in the availability and price of the above requirements, whether to produce or transport them, i.e. power, water, basic material, heating, cooling and not the least transporting goods and people. Hence the availability and price of oil will directly impact the price and availability of the human being critical needs and to a large extent his survival.
Consequences: The airline industry announced that they will lose $6 billion on international routes this year if oil stays at current levels. So British Airways and Virgin Atlantic recently announced that they are going to introduce a fuel surcharge of 6 sterling pounds per one-way trip on long-haul flights. Both justified the rise by saying that their fuel costs soared 45 percent over the past 12 months. For BA fuel is expected to be a hefty 225 million pounds higher this year than last.
It is not only the airline industry. An increase in oil prices will have an unequal impact across all businesses and consumers. Industries that are more dependent on oil like, transportation, shipping, courrier-delivery, and chemicals, will carry the biggest burden. Least sensitive are industries that don’t use much oil and pay a small percentage of their revenue for shipping cost like pharmaceutical, insurance and healthcare. Bottomline, high oil price will increase the operating expense of all companies but with various degrees - raw material, transportation, climatization, and power, which in turn depletes their profitability.
Investors usually panic with a sudden oil price increase, and this becomes obvious from the sharp sell-off in most stock markets. Some simply move out of equities, while others shift from oil sensitive companies to other industries. If an investor is confident that the high oil price is expected to last long, then it is prudent to move out of equities until the price settles. If however we are facing a short-term price hike, then the panic is unjustified and there is no need to dump stocks.
Outlook: G-7 countries feel the biggest impact in any oil price increase, due to their high dependence and large per capita consumption of oil. Since such countries are very powerful, they will not allow high oil prices to last too long, and will extend whatever effort is needed to solve the problems that caused oil price increase. Of course they will attempt this through peaceful means - twisting arms, and if necessary otherwise. The most important player in the above is OPEC group- with Saudi Arabia playing a leading role.
Currently they are producing a record 30 million barrels of oil per day and have indicated that they may raise the production quota in September. They have also announced that they will do their best to maintain adequate global supply of oil and at reasonable prices. Based on the above, I expect the hike in oil price to be temporary, and hence the long term impact on business to be minimal.
(Salim J. Ghalayini is a professional engineer and a seasoned investor. He manages several investment accounts.)