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Strong rand will provide market with soft place to land

Strong rand will provide market with soft place to land < News < Bet On Markets

High oil prices are likely to persist for at least the next 12 months, given the current dynamics in the industry.

For a greater part of the 1990s, oil prices ranged between $10 (R58 at Friday’s exchange rate) and $25 a barrel. Over recent years, this trading band has shifted upwards, with prices now trading between $40 and $60 a barrel. On Friday light sweet crude was at $42.25, while Brent was at $38.98.

Commodity prices are determined by the interaction between supply and demand, and the oil price has been driven by supply-side pressure, accompanied by growth in demand. Since most of these issues are unlikely to be resolved soon, it’s reasonable to believe oil prices will remain high.

From a supply perspective, the quantum of the world’s oil reserves has never been less certain or believable, as has been illustrated by the recent controversy surrounding Shell Oil, which misrepresented its reserves in an attempt to bolster its share price.

The sensitivities surrounding this issue have added another element of uncertainty to an already jittery oil market.

The supply of oil has also been hampered to a greater or lesser degree in most of the oil producing nations. Nigeria has experienced strikes, Venezuela and Saudi Arabia have political challenges, Iraq is unstable and Russian oil producer Yukos has an uncertain future.

The resolution of these impediments surrounding crude oil supply is unlikely to alleviate price pressures in the short term. Processing constraints, due to a lack of capital expenditure for new oil refineries over the past decade, have exacerbated an overburdened supply chain.

In addition, the 1997 Kyoto protocol, which aims to reduce emissions of carbon dioxide and other greenhouse gases, will also increase the cost of oil.

Carbon dioxide is emitted predominantly from the burning of coal, oil and gas in the creation of energy, and firms will be forced to upgrade their facilities to comply with the new emissions laws in most developed nations.

This excludes the US, which is not a signatory to the pact. The oil supplied by Saudi Arabia, for example, is of an inferior quality, with the result that the cost of processing this oil will rise significantly in order to produce good-quality fuel.

The critical question is: what impact will high oil prices have on our financial markets?

There are two schools of thought. There are those who believe that a high oil price results in higher inflation and weaker bond markets, and others who argue that, globally, gross domestic product is declining as a result of sustained high oil prices, supporting the bond market and putting pressure on equities.

Many local market participants with their focus on exports complain about the impact that the strength of the rand has had, but what they often fail to recognise is the extent to which the currency has protected our economy and financial markets from the potentially destructive impact of the oil price.

Furthermore, a considerable percentage of South African exports are destined for European and Asian markets, economies that have also experienced a significant strengthening in their own currencies, maintaining the competitiveness of the rand.

It is important to remember that although the oil price has increased in US dollar terms, the rand has also appreciated, with the result that the rand price of oil has in fact remained relatively stable over the past two years. In percentage terms, the rand has appreciated more than the US dollar has depreciated, minimising the impact of the oil price.

The impact of the oil price will, in effect, be determined by the currency, so that will be the key factor to watch over the next 12 months. If the rand weakens, the oil price will have an impact on local inflation and this is likely to be positive for equities and negative for bonds.

We expect the rand to remain strong to stable for some time, with the result that our financial markets will be cushioned against the potentially negative impact of a rampant oil price.

By Kimon Boyiatjis

Kimon Boyiatjis is head of fixed interest at Abvest.

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