Oil Market Report February, 2011

Whilst analysts can debate whether current oil prices represent a bubble or the true fundamentals of supply and demand, the issue of crippling increases in fuel costs is of far more importance to UK plc.

First the basics; the price rises on the back of the Egyptian uprising were largely speculative, or perhaps more fairly described as “anticipatory”. But the issues surrounding the cessation of Libyan oil production are rooted in the firm reality of product shortage. Egypt is not a major producer of oil and other than limited transportation of oil via the Suez Canal, events there should have had (in theory) a restricted impact on oil prices. But contagion is the fear of all oil buyers and the knock-on effects in surrounding countries and in particular Libya, have been significant. Unlike Egypt, Libya is a major producer, with most of its product ending up in European and UK Refiners *. It is the 3rd biggest producer in Africa (after Nigeria and Angola) and controls 2% of the world’s oil production.

Superficially, 2% sounds of little consequence, but that fails to understand the fundamentals of supply and demand. This lack of understanding was illustrated recently by French President Sarkozy when he declared “oil demand has not trebled, so why has the oil price?” This is rather a half-witted comment from a no-doubt intelligent man. Imagine a room of 10 very thirsty desert explorers and a vendor of water in the same room, with 10 bottles of water to sell. Each explorer desperately wants to drink and has plentiful supplies of cash to buy. So as long as supply and demand are in check (ie, 1 bottle for each explorer), prices will remain stable. Then consider the impact of 1 extra explorer suddenly arriving in the room. Sarkozy’s principle would dictate that the price should go up by 10%, because demand has risen by that amount. However, the price rise is now a function of how much each buyer wants the water. One explorer will inevitably go thirsty and if the thirst is great, how much is each explorer willing to pay to avoid that outcome? Prices could double, treble, quadruple even, until someone in the room admits defeat, misses out on the water and leaves. Suddenly prices go back down to normal, because once again supply and demand are balanced.

So a 2% drop in production, can have profound implications on an already stretched market. On 1st February, refined diesel was wholesaling at 46.26ppl (excluding duty, VAT etc) and by the end of the month, it had risen to 50.21ppl. A startling increase of 8.5% in one month. Let’s put that in real money. A local ironing service with 2 vans (we heartily recommend York Ironing / 07960 937395) will consume circa 400 litres diesel per month. So their costs have increased by £16 in one month and if the price stays where it is, an annual cost of £190 has to be passed on. A regional lift maintenance operation (20 vans) will consume circa 10,000 litres per month, so their costs will have increased by £400 in one month (£4,800 per annum). A food manufacturer, using 100,000 litres for their process dryers will have seen a £3,500 per month increase (£42,000 per annum), whilst a haulier with 40 trucks will be consuming 160,000 litres per month, giving a monthly increase of £6,300 (£76,000 per annum). Whether these businesses can survive is one issue, but more relevant to the end-user is that these cost rises need to find a home somewhere and the buck rests with the consumer. Every business that can, will pass the cost on and the only people who can’t, will have to pay. Prices on all goods will rise sooner or later.

At this juncture, predicting the oil market is less about technical knowledge of the industry and more about being a good political observer. The issue is simple. If the crisis in the Middle East and North Africa begins to abate, then prices will drop. But if the issues rumble on or even worse, spread, then prices will continue to rise.

* What on earth was Tony Blair thinking of? Hob-knobbing with evil dictators like Gaddafi to ensure we can maintain our oil supply. Everyone knows that principles take priority over cheap fuel… J.