Oil Prices and Petrol

Oil Prices and Petrol

As a critical commodity for powering the world, oil prices directly impact the day to day cost of living for almost everyone on the planet. In developed countries, the most visible impact of oil prices is through the cost of petrol (gasoline). While highly correlated with oil prices, petrol prices can also march to their own beat depending on market conditions. Petrol is derived from oil and is obtained through a process called fractional distillation. As a result of this extra processing step, petrol prices can deviate from oil prices as a result of variations in the output from refiners. Nevertheless, rising oil prices will inevitably cause petrol prices to rise so every motorist will feel the pinch.

Australian motorists will have noticed that petrol prices are at relatively low levels. Recently, prices as low as $1 /litre have been reached, a long way below the peak of $1.65 reached during 2008. The main factor causing this ‘cheap’ fuel is low oil prices which are fundamentally the result of an oversupplied market. Oil inventory data is published for the US each week and records the total amount of oil in storage. Although this is only US data, it can be viewed as a proxy for the level of over/undersupply in the global oil market. Current inventory levels are at extreme highs when adjusted for the time of the year. This is partly the result of new sources of supply that have come online recently. For example, in 2012 an international embargo restricted sales of oil from Iran. Prior to this Iran had been exporting 1.5 million barrels of oil per day making it the second largest exporter in OPEC (behind Saudi Arabia). The embargo caused a massive decrease in oil exports from Iran and tightened the worldwide oil supply. In January 2016, however, the sanctions were lifted as Iran reached an agreement with the UN on its uranium enrichment program. The effect of this has been an additional 2 million barrels of per day being exported from Iran.

With Africa’s largest oil reserves, Libya obtained much of its state revenue from oil and exported around 1.6m barrels per day to the international market. In 2012, the ‘Arab Spring’ in northern Africa spread to Libya and eventually led to the demise of dictator Muammar Ghaddafi. Unfortunately for Libyans, the downfall of the tyrant left a power vacuum that split the country and led to years of fighting. The result of this was significantly curtailed oil production with production in August this year down 84% from its pre-war levels. In September, however, oil production jumped significantly and the first ship loaded with oil has just left the Libyan port of Ras Lanuf, the first such shipment in two years. While this is undoubtedly good news for Libya, it is bad for an oversupplied global oil market.

Traditionally, OPEC would work together to adjust output to keep prices at a level they are comfortable with. More recently, however, the member states have been unable to reach any kind of production cut agreement as none of them wish to lose market share. The rise of US shale oil production actually gave OPEC some motivation to keep prices low in an attempt to bankrupt many of the high cost US producers. Unfortunately for OPEC, many of the US oil companies have managed to drastically cut production costs to keep their businesses viable even at the current oil prices. This presents a serious problem for many OPEC states who rely on oil revenues to fund government spending. Venezuela, for example, currently holds the largest oil reserves in the world (more than even Saudi Arabia) but the government depends heavily on oil revenue and is therefore vulnerable to low prices. As an OPEC member, Venezuela have been pushing for an agreement to freeze production however they have so far been unsuccessful.

With so many factors influencing the price it is virtually impossible to predict what prices will do in the short term. Investors in oil related companies implicitly take significant risk regarding the oil price and should be aware that these investments are therefore likely to be high risk. From an economy wide perspective, low oil prices can help put downward pressure on many other consumer prices and therefore benefit the average person.

This article was written by William O'Loughlin - Local Investment Analyst, Rivkin Securities Pty Ltd. Enquiries can be made via william.oloughlin@rivkin.com.au or by phoning +612 8302 3600.

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