Oil prices have risen to their highest levels in nearly a year, with the Brent spot price rising 30% since the beginning of last year’s ‘Arab Spring’ and the WTI spot price rising by 26% over the same period.
Supply shocks have been the dominant driver of oil price swings since unrest in the Middle East and North Africa broke out last Spring, embedding a risk premium into crude oil prices that remains today.
An improving fundamental picture in the US, continued robust oil demand from China and large liquidity injections by the world’s developed economies’ central banks have also been key drivers of the increase in oil prices. However, the main force behind more recent moves in oil prices has been the substantial increase in Iran supply risk, with Iran’s refusal to back away from attempts to build a nuclear weapon increasing the likelihood of a military conflict. Moves to embargo Iranian oil also threaten to reduce OPEC’s (the Organization of the Petroleum Exporting Countries) supply buffer, keeping the oil markets on edge. Aggressive action by Iran or further political and military upheaval in the region has the potential to quickly force prices back toward the highs witnessed in 2008.
There are of course also potential downside risks to the oil price. Questions about the sustainability of the recent rebound in US economic activity and the growth outlook for the rest of the OECD is likely to be a persistent theme in 2012. And while emerging market demand is likely to remain strong, a China hard landing scenario cannot be completely written off. Another key risk to monitor is investor speculative long positions in the WTI (West Texas Intermediate) and Brent futures market, which are now at elevated levels.
For now, however, with global growth indicators holding up, major central banks in aggressive easing mode and no signs of a resolution of the problems besetting the Middle East, oil prices appear to remain well supported. (article continues below)
Brent oil is increasingly being used by investors as the main way to hedge Middle East supply risks and gain exposure to global supply demand fundamentals, as WTI oil continues to be distorted by logistical problems at its delivery point in Cushing, Oklahoma. With limited infrastructure to take oil out of Cushing, supplies have built to such a level that WTI prices often reflect local balances rather than broader global supply demand balances.
For example, as the table below illustrates, during the “Arab Spring” period in the first part of 2011, when tensions in North Africa and the Middle East raised concerns about oil supplies from the region, Brent oil prices tended to react much more strongly than equivalent WTI futures prices. It is interesting to note that Brent’s outperformance was consistent even for longer dated maturities. The increased importance of Brent as the main oil price benchmark can also be seen in relative trading volumes, with trading volumes in Brent oil futures now nearly double early 2011 levels while WTI trading volumes, after a large rise, are relatively flat over the period.
Until the logistical problems at Cushing Oklahoma are resolved, it is likely that Brent oil will continue to be viewed as a better proxy of global oil supply and demand balances. Therefore, investors looking to hedge Middle East supply risks and global macro trends will likely continue to choose Brent exposures as their preferred investment vehicle.
Martin Arnold is senior analyst at ETF Securities.