Fundamental imbalances affect oil prices

Fundamental imbalances between supply and demand, and not speculators, are behind the spike in oil prices, according to a Morgan Stanley analyst.

"While speculators can have their moment on any given day, the overall trend really has to do with fundamentals," said Laura Ambroseno, Morgan Stanley executive director for MS Investment Management quantitative and structured solutions group.

Speculators have been often been blamed for the spike in oil prices, with leading Opec figures and government officials from across the globe questioning whether the likes of pension funds have forced commodity prices higher.

However, Amrbroseno cites the differing performance of various commodities as evidence that the speculator effect is exaggerated, claiming industrial metal prices have fallen by five per cent in the past year, while energy prices have soared over the same period.

"Some people say a new category of speculators have been driving prices, because of their investments in commodities indices, but if this were the case then all commodity prices should be moving together, with the less liquid commodities perhaps rising the fastest," said Ambroseno.

Further analysis supports her view. The number of speculative Nymex net long contracts – those that say oil prices will rise – has actually decreased from around 145,000 in April 2008 to less than 100,000 by June, yet the oil price continued to rise over this period.

"Prices have pretty much ignored the type of speculative activity captured in this positioning data and continue to march higher," said Ambroseno.

With the speculative case put in perspective, Ambroseno believes supply and demand factors are the true cause of the oil price spike. Structural demand is under pressure from cyclical factors such as economic growth and inflation, together with structural causes that include population growth and infrastructure development.

"The structural factors suggest commodity demand will be strong in the medium to long term," said Ambroseno.

The supply-demand imbalance will worsen in the longer term, because of capacity constraints, extraction costs, population growth, declining reserves and improved standards of living across the globe.

Structural demand pressures will remain strong. Oil production is expected to fall by three per cent a year between 2008 and 2017, from around 85 million barrels per day to roughly 65mbpd, while demand will increase by one per cent each year over the same period to more than 90mbpd, according to Morgan Stanley Research projections.

If these figures are correct, then there will be a global shortfall of 30mbpd by 2017.

Rising domestic demand in emerging markets has long been cited as a cause of soaring oil prices as the new middle classes raise consumption, but another factor Ambroseno highlights is the increasing economic independence of emerging countries.

"This has been a key factor in driving commodity prices higher over the past five years. Throughout the 1980s and 1990s, whenever US GDP growth slowed, so too did the GDP growth of emerging nations, but since 2000 this has changed dramatically," she said.

The three main components of a commodity are supply, demand and prices.

"Supply is quite tight and is unable to increase quickly, while demand is fairly strong, so prices are the key component to react. Rising prices have already caused demand to slow, particularly in the US. We do not know if oil could continue to hit $200 a barrel, but if it does, this will just further cause cyclical demand to adjust lower – a natural process in commodities markets," Ambroseno added.