Alliance Trust: Current outlook for oil

Angus McPhail, Global Oil & Natural Resources Analyst at Alliance Trust made the following comment on the current outlook for oil: "Oil prices have been extremely volatile over the last few months reflecting political developments as well as the flow of economic and oil market data. Over the coming months we see oil trading in a US$100-140 range in line with the underlying dynamics of supply and demand. We expect prices to be in the middle of this range at $124 over the next six months.

Market observers have been speculating about the role of demand destruction to explain why oil prices have cooled off from $140 to $120. The use of the term demand destruction refers to a permanent change in consumer habits and consumption patterns. A good example of this was seen in the early 1980s, when the second oil price shock led to a tripling in oil prices to above $40 per barrel. The response from the power generation and heavy industry was to switch into other cheaper fuel sources such as coal, which led to OECD demand falling between 1979 and 1994. The current oil shock may have led to some permanent changes in transportation notably in the US where demand for SUVs has fallen to all time low, however these changes are nowhere near as large as the response from industry after 1979. Demand for SUVs may have fallen but it does not mean that the demand for SUVs has been permanently dented. If anything lower US gasoline prices will cause demand for SUVs to come back. If consumers were selling their SUVs and switching to public transport that would amount to demand destruction. According to Barclays Commodities team US gasoline demand has declined relatively modestly compared to other oil products such as jet fuel, liquid petroleum gases and naphtha. If demand destruction really was gripping the oil market then for small changes in supply we would see large changes in prices in either direction. The body of evidence would suggest that demand has not weakened due to demand destruction but rather because of higher prices and will return once prices fall.

At the other side of equation lies the position of global supplies, with the majority of oil companies struggling to achieve meaningful growth in production with non-OPEC supplies being a particular point of concern. Any speculative froth in the market has been removed, and with global inventories still low the prospects of a higher prices moving into winter seem biased towards the upside."