Oil prices ride a wave of recent global optimism

FOR a long time, oil prices have been dominated by supply shocks, as one major oil producer after another has gone through a period of unrest. But while the Middle Eastern oil producers are still a long way from an oasis of calm, it is now expected demand-side improvements, rather than supply worries, that are driving prices higher.

CHINESE HOLIDAY
Brent crude oil prices hit a nine-month high on Friday, reaching $119 a barrel. They were given a big boost by a jump in Chinese oil imports in January, which reached their third highest level on record. Brent dropped a notch yesterday on thin trading, and with many Asian markets shut for Chinese New Year, this light trading is likely to continue for the rest of the week.

But in the short term, there may be some moderate support for prices from the US, should retail sales and industrial production data show any improvement in American macroeconomic conditions.

DIFFERENT DRIVERS
We have, of course, seen similar January surges for the last two years. However the causes of these previous rallies were very different. In 2011, it was Libya and the beginning of the Arab Spring that drove up prices, as political upheaval swept across the Middle East. In 2012, it was worries about Iran – the world’s fourth largest oil producer – that sent prices northwards. But this year’s surge has not been driven by these supply worries. Traders looking for the price to follow a similar pattern, based on those former fundamentals, would be mistaken.

OPTIMISM-FUELLED
As Goldman Sachs pointed out in a recent note, renewed optimism has mostly been based on momentum and forward-looking sentiment surveys than hard data. And if current high prices are to remain supported, there needs to be some improvement in this data to follow it up.

To support this view, Goldman points to a comparison between oil and copper. Both are heavily driven by economic growth. But while copper has shown some recent gains, it has been significantly outpaced by oil. Goldman highlights this as the difference between optimism driving oil, and the need for positive hard data to get copper up and running.

DEMAND DESTRUCTION
Some have cited $120 a barrel as a level above which we will start to see some demand destruction, particularly from Europe. But these claims tend to be made whenever the oil price reaches a new high that ends in a “0”, and do not play out in the real world. We live in an industrial, heavily oil-dependent economy, and oil is not a substitution good in any real sense. At most, any demand destruction will occur at the margins.

It is too soon to say whether this oil price bullishness will play out in the coming months. But while upside has not been driven by supply shocks so far this year, as we have seen before, it only takes a small amount of violence in a major oil-producing country to send the oil price rocketing.