RIYADH, 25 April 2005 — What will you do if the price of water goes up by 100 percent?
Stop using water, drink less, or use the water saved in your storage tank, find alternatives to water, or maybe exert pressure on your water supplier? Fortunately this has not happened, but in fact it is business as usual for oil, and the above options apply as well.
The future price of oil is a topic on which very intelligent and well-informed people have divergent views. Some predict that oil would soon sell for more than $100 a barrel, while others forecast that oil would average just $25 a barrel in 2005. Those who are confident of their prediction can turn their knowledge into big profit.
Significance of Oil: Oil is a critical commodity that is needed for human survival, like water, food, or shelter. Oil is used to produce many commodities, heating and cooling our working and living space, in addition to transporting goods and people. Individuals and countries become very nervous if they are deprived from oil, due to disruption of supply or sudden increase in price.
Price Volatility: The market for oil carries more risk of huge shocks to supply and demand than markets for most commodities. An increase in demand faster than the supply will result in a quick price increase. The demand for oil could be hurt suddenly — for example if someone invented a portable fusion generator that could safely power a car or heat a house. On the supply side people are very worrisome, and every time a fire starts or a car explodes in or around the GCC countries, a hurricane hits London and New York.
Volatility is based on supply and demand but more on fear of supply disruption. It is based sentiment, unlike economic fundamentals. Unrest in Iraq, political problems in an oil producing country, terror attacks or threats to western interests around the globe etc.., create uncertainty and high risk which contribute to sharp increase in oil prices.
According to scientific models, if oil were to trade on a free market among profit-seeking buyers and sellers, the average price at present would be around $39 a barrel instead of $56. You still have a speculative premium in crude oil of around $17 a barrel in today’s price.
End of volatility? Volatility can be suppressed through reducing dependence on oil, by finding alternative sources of energy. Currently there is a serious effort in the United States to switch vehicles to natural gas, or other energy sources. Similar investigations to discover alternative sources of enegry has been going on for over ten years but have produced little tangible results.
Consequences of High Oil Prices: Nearly all countries are net importers of oil. An increase in oil price hits the pockets of most people in all but few countries. Oil is used by people directly or indirectly for transportation, climatization, basic utilities and most important in the production of their basic daily goods. Higher oil prices will increase the operating expenses of most companies and reduce their profitability however the additional cost is passed to the consumer. If the price becomes unaffordable to the average citizen, then the matter gets manifested into civil unrest that leads to serious political consequences.
Globally an increase in oil price has a negative impact on the balance of payment, the national economy, and is the most common cause of recessions in various countries. Strategically countries need oil for their defense and national security, and will get very nervous possibly aggressive if they can’t afford to get enough to satisfy their needs.
The above concerns do not apply to oil producing countries like Saudi Arabia. In fact such countries benefit from an oil price increase. High prices provide needed revenue to support the economy in the near term, however a long plateau of high prices might encourage people to seek other sources of energy, or it might turn strong countries violent. Hence striking the right balance is extremely important.
Saudi wealth increased substantially during the past thirty years. At current production levels, every $1 increase in the price of one barrel of oil translates into an annual income increase of SR10 billion to Saudi Arabia. Of course the longer a price increase lasts, the higher the income it produces to an oil exporting country. Since oil price increase cannot be planned or budgeted for, the additional income comes as a “bonus” on top of the normal government budget which produces a surplus or is used for discretionary public spending.
The Saudi oil revenue represents 80 percent of exports, and is used in development, education and social programs, which gradually leads to prosperity and stability. Personal wealth increased as a result of public spending, and many private businesses and projects mushroomed in various parts of the country. Diversification, high-tech, and human instinct prompted a sizable amount of the Saudi wealth, both private and public, to get invested in the United States and other Western countries.
During 2002 and 2003, around $100 billion were transferred back to Saudi Arabia. A sizeable amount of this wealth was invested locally in real estate, transportation, light industry, among other sectors. This left additional funds still looking for a place to invest them in. The Saudi stock market was young and developing, not properly tested and has limited visibility. Timely information about listed companies were hardly available, security analysis was in it’s infancy, and hence the interest in the stock market was restricted to a small number of investors.
Privatization and the great success of several initial public offerings (IPOs) like Saudi Telecom, Etihad Etisalat, National Company for Cooperative Insurance (NCCI) and Bank Albilad, added more visibility to the Saudi stock market during the past few years. In fact such events produced many investors who made big profit over a short period.
The additional idle capital quickly found it’s way to the stock market. Due to the availability of lots of funds and a limited supply of companies to invest in, stock prices increased dramatically based more on speculation and less on performance. The Tadawul All-Share Index (TASI) posted a gain of 76 percent in 2003, almost doubled in 2004, and is up around 30 percent so far this year. Of course we are witnessing a stock price bubble with above average PE ratios, that sooner or later has to slow down or get deflated. Thanks to the above, the Saudi stock market is now the largest in the region with a market capitalization of SR1.3 trillion.
Oil price increase is cyclical, which means that an increase is normally followed by a decrease. Countries in the West have an addiction to oil. The biggest per capita users of oil are the highly developed countries that will be impacted the most by any oil shortage or a price increase. When the price reaches a dangerous level these countries have the power to trigger a direction change in the cycle through peaceful means or otherwise.
(Salim J. Ghalayini, [email protected], is the author of “Stocks for the Practical Investor”. He manages several investment accounts.)
