Friday, October 13, 2006

Oil prices decreases:Is it permanent or transitory?

Available evidence (De Gregorio ,Landeretche and Nelson 2006,mentioned by Central Bank of Chile in its september monetary policy report))suggests that the link between oil prices increases and inflation has been weaker in recent years than what it supposed to be. While in the period 1967-1980 ,an increase of 1% in oil prices meant a cumulative increase of 0.48% in the long run inflation rates, in the period 1980-2006 that impact was just a barely 0,06%.Considering the years 1990-2005 ,such impact of oil prices increases, has been even lower, 0.03%.Therefore, given the magnitude of this effect, current lower oil prices would not necessarily will mean a significant relief for current inflation rates, although if it is permanent it might induce inflationary expectations further downward. In such a case, the positive effect is upon the chance of not just keeping down inflationary expectation, but also because it would allow Central Banks to take a softer approach on inflation, moderating the slowdown impact on economic growth of increase in interest rates.-
What is the explanation for this oil prices decline?. Given that there are supply and demand explanations, it would be important to know the share each factor (supply or demand, being speculative or geopolitical) has on oil prices behaviour at this time. At first glance, it appears that lower global demand is driving oil prices down. The demand expectations for this year is to have an increase of about 1.2% less than what it was expected a few month ago. Concerning the supply there is still no agreement on oil exporting countries about the reduction levels in oil production to counter balance this downward price trend .
Therefore there is not clear indications whether this decrease in oil prices is going to be permanent or transitory .However for the year 2007,markets expectations (oil options markets transactions), indicates a roughly 50% probability that oil prices will be in the range of U$$65 to U$$85 a barrel,(Central bank of Chile ,Blommberg .September 2006) recovering itself from the current below sixty dollars level. The remaining 50% it is roughly split off between the lower range (25% probability of being below U$$65),and the higher range ( 25% probability of being above USS 85). So ,it looks like at least partially, there is a correction in oil prices. This means that only part of the current reduction in oil prices, would be due a decrease in global demand, probably the more significant one related to the US economy slow down. On the other hand ,it is not unrealistic to assume that speculators are changing theirs portfolios to a more secure assets, moving away at the same time (it is a fact that Us economy is slowing down its growth ) from commodities. Global Information available allows them to make such kind of decisions. In this scenario , current oil prices reduction would be transitory.
What about the chance of such oil prices reduction to be permanent? :it is unlikely that oil exporting countries will no react to prices movement .The oil cartel means a strong incentives to act in a coordinated fashion to restraint production further, such as to keep oil prices stable to its mid term levels (probably around sixty or sixty five dollars).At the same time demand is expected to growth although at a lower pace (1.6% next year ,down from 1,7% growth a few month ago)because of the just mentioned US economy slow down. But ,whether as it is expected ,such slow down turn out to be short lived , global demand for oil resources will move back upward again. Therefore the chances of having a transitory oil prices decreases are higher, than the chances of having permanent oil price decreases.-

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