“Until recently, my mornings started with a check on the Italian bond yield,” says Wall Street strategist Ed Yardeni. Not anymore, though. Now he checks the price of Brent crude first.
In a week when oil prices jumped to more than $125 a barrel, their highest since last year’s civil war in Libya, the attention of investors has shifted palpably: from the crisis in Greece to the threat from crude. If it continues to rise – and the world’s biggest independent energy trader Vitol has warned a rise to $150 is possible – then any immediate prospects for recovery in Europe, especially, are likely to recede.
There are several reasons for the gains in oil, the most important of which is growing tension over Iran’s nuclear programme. Planned European Union sanctions and counter-threats by Iran to cut supplies have unnerved traders. In sterling and euro terms, Brent hit record highs this week. On Friday, it leapt to new nine-month highs of $125.47, boosted by a report from the United Nations nuclear watchdog that Tehran had sharply boosted production of higher-grade uranium.
“Crude oil is moving towards the tipping point,” says Michael Lewis, head of commodities research at Deutsche Bank in London.
The rise in oil prices, just as America begins to show signs of emerging from the economic quagmire is ominous for the global economy. Almost all previous US recessions were preceded by a big surge in energy costs. The cost of petrol in the US is edging up towards the psychological level of $4 per gallon, a level likely to sap consumer confidence.
According to James Hamilton, economist at the University of California in San Diego who has studied the impact of oil prices on economic activity, “all but one of the 11 post-war recessions [in the US] were associated with an increase in the price of oil, the single exception being the recession of 1960.”
Europe could feel the impact harder. For all the efforts by the region’s refiners to secure alternative supplies, this week’s rally will hurt countries such as Greece, Italy and Spain, because of their economic fragility.
Didier Houssin, director of energy markets and security at the International Energy Agency, the western countries’ oil watchdog, told an industry conference this week that high oil prices were already acting as a brake on economic growth. He said that the “oil burden”, or the cost of crude as a proportion of gross domestic product, was near 2008 levels, when oil rose to a record $147.
Deutsche Bank estimates that if even if oil prices only remain at current levels for the rest of the year, that ratio will rise to 5.5 per cent, above the 4.8 per cent of 2008 and the highest since 1983.
The sharp gain in oil is due to a combination of supply disruptions as well as fears about the impact on Iranian exports from US and European sanctions. In Asia, and particularly Japan, robust demand for crude has contributed to market tightness.
Colin Fenton, head of commodities research at JPMorgan in New York, says that the rally in prices is “economically driven and physically rooted”. The risk premium due to Iran, he says, accounts for just “a few dollars per barrel”.
South Sudan has stopped pumping nearly 300,000 barrels a day of sought-after low-sulphur crude. Political unrest and strikes have removed about 250,000 b/d of supply from Yemen. Libya is pumping roughly 1m b/d, which is still well below the pre-civil war level of 1.6m b/d. Syrian output has dropped by about 150,000-200,000 b/d due to the turmoil there.
These supply disruptions have tightened the physical market to a degree that has surprised executives at Swiss-based commodities trading houses and many experienced analysts.
Paul Tossetti of consultants PFC Energy in Washington says that the physical oil market is “tight and looks like could get tighter”.
Ageing infrastructure and oil fields are also contributing to higher prices. Crude oil output in the North Sea is falling and Venezuelan production is also sharply lower.
Demand in Asia has picked up in large part because Japanese power generators are turning to oil as an alternative to atomic power in the aftermath of last year’s tsunami and Fukushima nuclear disaster. Only two of Japan’s fleet of 54 reactors are operating, forcing the country to consume more fuel oil and crude for direct burning to generate electricity.
David Wech, analyst at consultants JBC Energy, says that Japan consumed a combined 635,000 b/d of crude and fuel oil for power generation last month, more than double the amount from a year ago.
The IEA, for its part, estimates that global oil consumption will grow by 830,000 b/d this year, more than the 740,000 b/d growth in 2011. “A two-speed outlook prevails,” the agency said on its latest monthly report, anticipating “robust oil demand growth” in emerging countries while consumption continues to fall across most developed nations.
Should oil prices head towards $150, the gains could prove shortlived if, as in 2008, a slide back into recession sent prices tumbling again. But that would be scant consolation.
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