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Fear factor and soaring demand blamed for crude price leap

By Kevin Morrison and Stephen Schurr

LONDON: Since the price of oil began its rocky but seemingly inexorable climb above $40 a barrel in 2003, there has been widespread debate about what is driving it.

Crude bears have contended higher energy prices are heavily influenced by a “risk premium” amid fears of terrorist or political disruptions to supply. Bulls, conversely, acknowledge a premium, but say it is far less important than the soaring demand from developed and developing countries amid ever-tightening supply. So far, the bears have been punished mightily, while the bulls have been among the best-compensated investors in the world.

“Clearly, there is some risk premium,” said James Melcher, manager of Balestra Capital, a New York-based hedge fund that has notched up strong returns in recent years in part thanks to energy related bets. “If the Israeli-Palestinian mess simmers down, Venezuela settles down and the Iran situation progresses in a benign way, I think oil will come down to maybe $55 or $60 — but it isn’t going back to the $40s.”

There has been no shortage of events to fuel the fear factor. Notwithstanding the failed attack on Saudi Arabia’s Abqaiq facility, Nigerian militants closed significant parts of the country’s production early this year. There are the continued attacks on Iraqi oil infrastructure and the nuclear stand-off continues between Iran and the west. All of which have kept oil traders busy, and stoked concerns about future oil supplies, which has helped push oil prices to more than $70 a barrel this week.

For hedge fund managers such as Mr Melcher, there are plenty of ways to profit from higher energy prices without a direct investment in crude.

For instance, Balestra has 80 per cent of its energy holdings in oil service companies. “With prices at higher levels, margins for these companies are exploding,” said Mr Melcher.

But geopolitics is just one of several factors affecting oil prices. More mundane ones include oil demand, the level of oil inventories, and refining constraints. Francisco Blanch, head of commodity research at Merrill Lynch, says that a closer look at the oil market shows that oil supplies have not been disturbed to any great extent. In fact oil held in storage in developed countries is at its highest level in more than 20 years, even higher than in 1998, when big inventories contributed to the oil price falling to $10 a barrel.

Moreover, Iraqi oil exports this month are expected to rise to their highest level since October 2004, as oil from the northern Kirkuk oil field starts to flow again for the first time since September. The shutdown of about 500,000 barrels a day of Nigerian production by rebels has been partially offset by production from the new Bonga field.

“I think the geopolitical situation is probably a bit better than the general perception,” said Mr Blanch. Even the likelihood of Iran using oil as a strategic weapon in its nuclear negotiations is remote, he adds, given that the country is actually dependent on foreign imports of petrol as a result of insufficient refining capacity.


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