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Where is the oil price going?

This week I went to fill up my car and my heart sank as I realised I was paying more than £10 more to fill up my little car than I did this time last year. Traffic conditions haven’t changed, the amount I’m driving hasn’t changed, even tax has been frozen, instead it’s the oil price, coupled with the value of the pound, that’s making me stretch my income. But oil isn’t just about petrol, it impacts our investments, so is there anything positive to be taken from the higher oil prices, and where might they go in the future?

Oil prices

This time last year oil was rather cheap, it dropped to under $30 a barrel, now it’s about $55 a barrel. Whilst we might despair at the price of petrol it’s important to remember that a higher oil price is correlated to many other things, particularly equity, and a rise in the oil price has in the past led to a boost in equity indices.

Many participants seem to be predicting that oil prices could go higher. Some of this might reflect optimism towards accelerating global growth.

A supply challenge

Part of the reason behind the price rise was the announcement from Organisation of Petroleum Exporting Countries (OPEC) in November that they would cut oil output. Through much of 2016 oil was in over supply. However, OPEC countries are not the only countries that supply oil, and non-OPEC countries do not have a cap on production. Since prices have risen there have been some indications of increased supply.

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In the early 1970s OPEC production cuts were very effective and have helped to protect the long-term oil price. In recent years OPEC cuts have been less effective, this is partly due to the growth in non-OPEC producers. US shale oil has been around for a few years and has led to a pick-up in overall US oil supply, which has had a negative impact on the oil price.

Oil producers in Saudi Arabia responded to this by not cutting production, and supporting the new lower price. Oil prices fell from $100 per barrel to below $50. The number of US oil rigs dropped, but US oil producers became much more efficient, the impact on output was limited. The US rig count has started to rise again, suggesting US oil producers can make money with prices in the low-50s.

What does this mean for investments?

There are a few interesting take-aways from recent movements in oil. First, the oil market, like the equity market, appears to be betting on an acceleration of global growth. Second, a combination of low volatility and speculative long positions suggests that there’s some risk that oil prices might fall, especially if global growth begins to disappoint. This points to a need to manage risk in investment portfolios tightly by ensuring a diverse asset allocation.

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