Monday, March 24, 2008

Forecast for Oil Prices

Readers Question: You are a market analyst specialising in the oil industry and have been asked to forecast the likely price of oil in 2008. Carefully explain the reasons behind the forecast you make.

Oil Price Increases

Oil prices have increased significantly since 2003. They are now trading at over $100 a barrel and there is uncertainty about their future directions.

Graph of Oil Prices

oil prices

Future Direction of Oil Prices

It really is quite difficult to predict oil prices in the coming 12 months. The rise in the price is partly due to demand rising faster than supply however, it is also been driven higher by speculation. It is difficult to know how the markets will treat oil in a climate of increased financial insecurity. However, I would expect oil prices to remain above $100 and possibly even increase by another 10%

Factors that will cause Rising Oil Prices
  1. Continued growth of Chinese and Indian economy. With China growing at 10% a year and India growing at 7%, there is a strong and continued increase in demand for oil. It is important to bear in mind the significance of these increases. Rising demand from China is likely to outstrip a slowdown in US.
  2. Demand is Income Elastic. As China, India and other countries develop there is evidence that demand for oil is income elastic. It means that as income rises the new middle class consumers spend a bigger % of their income on cars and petrol. Therefore demand is quite significant.
  3. Constraints on Supply. Political uncertainty in the middle east, especially around Iraq and Iran is putting limits on supply of oil. Therefore, this raises scope for future higher prices. There still seems to be some difficulties around the supply in countries such as Mexico and Siberia. If these are unresolved prices could continue to rise.
Forecast for the Dollar Price of Oil

It is important to remember that oil is price in Dollars. Therefore the rise in the price of oil is partly caused by the weakness of the dollar. Measured in Euros or Yens, the rise in price of oil is less significant. However, the outlook for the Dollar remains poor in 2008. The Fed have cut interest rates sharply in response to impending recession. A recession will weaken inflation and enable interest rate cuts. Lower interest rates attract less hot money flows.

The Difficulty of predicting Oil Prices.

There is a strong element of uncertainty about future oil prices. This is because oil prices are often driven by speculation and non-fundamentals. e.g. high growth and high demand are fundamental reasons explaining higher prices, but oil prices are also determined by speculators and their general mood. For example, the assassination of Benazir Bhutto was said to have explained a temporary increase in the price of oil. However, there is no obvious link between her death and the supply and demand of oil.

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