Oil markets are too important for volatility

Oil production in Iran

ALASTAIR Darling calls it a “growing concern”. Barack Obama has gone further, labelling it one of the world’s “most dangerous weapons”. However either men describes it, they both view rising oil prices as a serious impediment to emerging from recession.

Here, the Chancellor has done little more than sound a warning. “While inflation has not been the major worry over the last year, global oil prices, up by over $25 a barrel in three months, are again a growing concern,” he said. “This has the potential to be a huge problem as far as the recovery is concerned.”

The US president has gone further. His administration is currently drawing up plans to give the Securities and Exchange Commission and Commodity Futures Trading Commission “clear, unimpeded authority to police and prevent fraud” in the derivatives markets. Obama says the plans will subject large financial businesses to close, co-ordinated supervision and regulation, aimed at encouraging market discipline and transparency. This will, he says, have the added benefit of giving the US economy enough strength to withstand the collapse of a Lehman Brothers-sized business, adding: “It is an indisputable fact that one of the most significant contributors to our economic downturn was a unraveling of major financial institutions and the lack of adequate regulatory structures to prevent abuse and excess”.

The UK and European governments have plans to follow the US with regulation proposals this week. So far, Darling has only announced his hope that oil-producing states in the Gulf will see the knock-on effects if they raise prices and “snuff out a recovery”. Obama may have gone for the middlemen first because he recognises that the influence that his government can bring to bear on the Organisation of the Petroleum Exporting Countried is becoming ever more limited.

Saudi Arabia has become the weak link in the chain. Even though it remains the world’s biggest producer, its position as the big man at the table has grown less and less since 2004 when, at the behest of the Bush White House, it failed to halt a breakaway from OPEC-fixed prices, of between $22 and $28 a barrel, by proposing an additional two million barrels a day to keep within the price bracket. It was ignored, and so the Saudis resorted to taking up the increased production all by itself. Crucially, this failed to halt the rise in prices, because the country’s excess capacity is made up of heavy crude oil that is too expensive to refine, or can only be processed in a limited number of specialist refineries.

Prices continued to climb, to last summer’s high of $147 a barrel, before falling off a cliff as the recession swept around the globe. OPEC members, including Saudi Arabia, reduced production by 1.5m barrels a day in order to reach a target price of $75 a barrel. Latest import figures from China, released today (MON), will be closely analysed by the White House, too. They show that, for the first time, Iran has overtaken Saudi Arabia as the country’s biggest supplier of crude, shipping some 727,000 barrels a day in May. Saudi’s slip, down 15.5% to 650,000 barrels a day, is mainly because OPEC cuts have concentrated on the heavy grades that it once provided and which China now requires. China has also contributed to price rises by being particular about which grades they take.

Obama will have taken some comfort from other recent developments within OPEC. Current president Angola says it is unlikely that the group will cut production in 2009, leaving the price at between $70 and $75 a barrel. Angolan oil minister Jose Botelho de Vasconcelos told The Guardian: “The (OPEC) goals are being met and I think that if by the end of the year prices remain at the $70-$75 level that will be positive for the economy.”

Those estimations are consistent with Western analyses – but only just. Stuart Thomson, chief economist at fund management group Ignis, believes that oil at $80 dollars per barrel will damage the recovery while oil at $100 would put the economy back into recession. “As well as the risk to consumer spending there is a risk that the oil price could feed through to bond yields and from there could lead to higher mortgage rates and stop the housing recovery in its tracks,” he added.

But the recession is also a major concern for other OPEC members, and they could lobby for a price rise to swiftly alleviate their own problems. Dubai’s case is most pressing. The property bubble on which the emirate is built has spectacularly burst. House prices have already halved, and UBS predicts that they will fall by a further 20%, making it the worst affected property market in the world. State-backed businesses such as the developer Nakheel have seen their credit ratings downgraded or even put on negative watch, while government debt and that of the companies it backs has soared to $80bn, more than Dubai’s GDP. Some $11bn will come this year, and $12.4bn is forecast for 2010.

This has forced the city state’s rulers to turn to its oil-rich neighbour Abu Dhabi for a $20bn bailout. This is not that surprising, as all of the Emiriti states have vested interests in seeing Dubai succeed. However, concerned that they may need to recoup their investments elsewhere, they may well fall back on their primary export as a means of balancing the books.

But this may not have the desired effect. Dubai relies upon the West for its business expertise. And while Britons have invested more money privately there than any other nation, it also provides a good share of managers, directors and other crucial staff to run its businesses, hotels, banks, airlines and infrastructure. If skilled staff see panic in UAE economic decision-making, they are less likely to risk a move – often with their families – across the world.

Seasoned Gulf watchers say that Dubai is too big and too well invested in to be allowed to fail. But its vulnerability, which has become tied to the fortunes of Western economies, shows an interdependency on oil that is difficult to unpick, and reinforces the requirement for cool heads with long term views ahead of speculation on this most volatile of commodities.