Will oil prices crash soon?

With crude oil currently trading at $136 per barrel and petrol prices nudging $4 per gallon in the USA and more than £5 per gallon in the UK, some people are starting to predict an imminent crash in oil prices.

Oil prices have virtually doubled over the last year and although it has pulled back slightly from their record high set a few weeks ago, oil is still trading near the top of its range.

Some investors are starting to feel concerned about the sustainability of such high prices, and feel that their oil dependent investments may be at risk, should there be a crash in oil prices soon.

We will examine some reasons why oil prices are likely to remain at current levels for some time, however investors should make their own decisions about their investments.

The strength of the dollar

As oil is priced in US dollars, the strength or weakness of the dollar has an impact on oil prices.

Recent weaknesses in the dollar have contributed to rising oil prices, however a strengthening dollar is likely to trigger a reduction in the cost of oil.

With US interest rates at 2%, but inflation increasing and consumer demand falling, the Fed is in a difficult position with regards to setting interest rates.

Although the Fed would probably like to raise interest rates today, to help reduce inflationary forces, yesterdays news about a collapse in consumer confidence and with house prices suffering their biggest decline for two decades, the Fed is unlikely to increase interest rates today.

As an increase in interest rates would strengthen the dollar, todays decision by the Fed is likely to have little or no impact on oil prices. Oil prices may even rise if interest rates remain at 2% today.

OPEC oil supplies

Political pressure has been brought to bear on Saudi Arabia to increase their output of oil. A greater supply of oil should result in lower prices as long as demand remains the same.

Even though Saudi Arabia has agreed to supply an additional 200,000 barrels per day from July, it only represents an increase of 2.1%, and hasn’t, so far, triggered a fall in oil prices.

OPEC, which produces 40% of world crude oil, is opposed to increasing supplies further. “OPEC has already done what OPEC can do and prices will not come down,” the president of OPEC advised recently.

So with the major oil producing countries reluctant to increase supply significantly, we can expect little downwards pressure on oil prices from the agreement with Saudi Arabia.

Political tensions

Tensions within oil producing nations fuel oil price increases.

There are two tension hotspots at the moment. The ongoing threat by Israel to destroy Iranian nuclear capabilities is helping drive oil prices upwards.

Iran is a major oil producer and may threaten to shut down its supply in the face of antagonism from Israel.

That tension exists between Israel and Iran is sufficient to help maintain oil prices towards the top of its trading range.

The other area of concern is the terrorist actions against oil installations in Nigeria. Militants destroyed an oil pipeline last week forcing Chevron to reduce supply by 120,000 barrels a day.

Whilst Nigerian oil supplies remain under threat from terrorist action, an upwards pressure on oil prices will continue.

Investor sentiment

It is estimated that speculation by institutional investors is contributing to around 40% of the oil price.

As huge investment funds have retreated from personal and commercial lending and property investments, the surging oil futures market is proving an attractive alternative.

The oil futures market is currently trading oil at around $137 per barrel for the rest of this year and pricing it at around $136 per barrel for 12 month contracts.

This indicates that investors expect Nymex Light Crude oil prices to remain at these levels for some time, however these futures prices can fluctuate with events and investor sentiment.

Visit this page if you are interested in seeing how oil is priced in the futures market.

Destruction of oil demand

High oil prices are impacting consumers badly. It is estimated that gasoline consumption in the USA has fallen by 2.7% compared to last year.

In an effort to save energy costs, consumers and companies are actively looking to reduce their energy consumption. Economic slowdown in many Western countries is also reducing demand.

Rapid growth in China and India, however, is creating a surge in oil demand at a time of dwindling supplies. Strong fundamentals, such as demand and supply imbalances drive the oil price upwards.

Given the problems that high oil prices cause throughout the world, a crash in oil costs would be welcome by many.

For the reasons stated, however, we take the view that the futures market is a good prediction of where oil prices will be within the next few years, and are therefore unlikely to crash soon.