“I think we agree: the past is over” - George W. Bush

Fuel prices hit record highs earlier this month – a sobering point against the backdrop of renewed fears of inflation. Petrol is at the whim of global oil prices, which have skyrocketed over the past few months after a decade of steadily falling. In this article, I’m going to break down the factors contributing to oil prices over the past decade, with an emphasis on the highs of the previous few months, and make a prediction of future oil price movements.

Oil is a fungible commodity with global demand. Oil’s linchpin role as a strategic commodity has spawned an array of derivative financial products; among other things, these attempt to smooth any sudden, jarring movements in its price. 

As such, there are three proxies for oil prices globally: futures contracts for West Texas Crude, Brent Crude (which comes from the North Sea, between Scotland and Norway), and Dubai Crude. These contracts allow their buyers to purchase oil at a later time for a predetermined amount; they are an effective hedge against the risk of a significant increase in the price of oil globally. New Zealand buys most of its oil from the Middle East, so contracts for Dubai Crude are our go-to, but there is a strong correlation among the three. 

Oil prices began to decrease about a decade ago, as the world stumbled into what we now call the “2010s oil glut”. North American shale production increased with resurgent interest in hydraulic fracturing amidst successful lobbying, and Russia and Saudi Arabia entered a price war with each other, increasing production in order to push prices lower and lower. More recently, global lockdowns attributed to COVID-19 have seen demand for oil slump, as entire populations awoke to the possibility of a world at home.

Consequently, on the 20th of April 2020, WTI futures were trading at $-37 per barrel. Due to the cost of renting storage and workers, et cetera, holding on to oil was more expensive than selling it, and firms were eager to divest. This couldn’t be passed on to consumers for the simple reason that there was no incentive to do so – supply had massively outpaced demand, and there was no practical reason for firms to consider passing those costs to consumers.

But what changed? Put simply, currently-high prices can be traced to two major factors: COVID-19 causing havoc in downstream oil and gas, and the Russo-Ukrainian War.

It’s important to recognise that the oil and gas industry is split into three sectors: upstream, midstream, and downstream. Upstream typically refers to the more hands-on jobs like exploration, drilling, and extraction; midstream typically refers to wholesale activities, like bulk transport; and downstream oil and gas, by necessity, refers to the refinement and distribution of these products to retail customers. The downstream sector has been operating below capacity due to Omicron’s ability to surge through workplaces and incapacitate staff, an impact felt not only across oil and gas but across the entire global economy – this is one of the most significant causes of recent inflation, after all.

Additionally, the Russo-Ukrainian conflict has had an impact. As the world’s second-largest oil producer, Russia enjoys a proximate relationship to global oil. As a result, oil prices are also sensitive to the state of Russian affairs, both domestically and abroad. The country’s surprise invasion of its erstwhile ally, Ukraine, has led to pandemonium in global markets, which are generally averse to such unpredictable events. 

It was this two-pronged combination of factors that led to New Zealand petrol prices being so high earlier this month. But things seem to be changing: anticipating the end of the COVID-19 pandemic, companies are returning to work. The bellwether for this is surely the resumption of international travel, even among states with notoriously strict border restrictions, like Australia and New Zealand.

Additionally, a combination of mounting losses, insufficient strategic gains, and an overall lack of morale suggest that Moscow may be reconsidering its western ambitions, at least for now. Ukraine and Russia have been in talks recently, with a scaled-back assault on Kyiv as a result, and it look like Russia might seek Ukrainian capitulation via the cession of Donbas (parts of which have been controlled by separatists since the mid-2010s).

Where does this lead us? What will happen to oil prices in the future?

For starters, petrol prices in New Zealand have been cooled down by the Government’s $0.25/litre excise tax cut. This, combined with GST, has seen a $0.29 reduction per litre, and petrol prices have now dropped below $3/litre.

The petrol industry is highly sensitive to scale, so a large-scale return to work will see prices drop even further. Over time, as supply chains improve their resilience to COVID, firms should be able to either mitigate their exposure through redundancy or develop appropriate strategies for dealing with sick staff.  In the long term, structural factors that underpin oil production will likely keep prices low.

But let’s look beyond theory. We can see an explanation of this effect by considering the price of Dubai Crude futures, which are decreasing exponentially over longer settlement times. We can, therefore, imply that investors are looking to hedge their exposure in the short- to medium-term, with an assumption that prices will stabilise in the long-term.

Overall, this seems the most logical course. COVID-19 seems to be falling out of the national consciousness as people adjust to their “new normal”, and hermetic states are willing to risk the irreversible step of opening their borders for the first time in several years. Additionally, Western support is appearing to bring the Russo-Ukrainian conflict to a stalemate. Over time, the structural factors that outline the current market will change. As electric cars grow their market share, demand for gasoline and diesel (which make up the lion’s share of petroleum products) will reduce, putting less demand-side pressure on oil, suppressing prices.

It seems, then, that while oil has recently been for a turbulent ride, it’s starting to settle, and should soon return to where it was a few years ago.

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APRIL 4TH 2022 | ISSUE NO.31