Friday, May 14, 2004
A Q&A on oil prices
Posted by David Smith at 07:50 PM
Category: Thoughts and responses

Why are oil prices so high?

At nearly $41 a barrel in New York on Thursday night and $38 in London (the difference is explained by different grades of crude oil), prices are within a whisker of their highs of 1990, the run-up to the first war against Iraq. A barrel is equal to 35 Imperial gallons.

The 1990 date gives a clue to one of the big reasons for higher prices - continuing tensions in Iraq and the Middle East since the end of what George W Bush described as the major combat phase of the war. Oil production in Iraq has recovered to prewar levels, but analysts say that even these levels are unsustainable without big investment in the country's oil infrastructure.

Add to that a "synchronised" global economic upturn, with America, Asia and, to a lesser extent, Europe all growing together, and some upward pressure on oil prices was inevitable, although probably not as much as we have seen.

What else has been happening to boost prices?

America, China and India, among others, have been adding to their strategic oil reserves, thus boosting demand. The big fear among oil consuming nations is of a disruption of supplies from Saudi Arabia, the world's biggest producer, now also subject to increasing political tension.

There are also supply bottlenecks, notably a shortage of refinery capacity in America. This means that rising crude oil prices result in even higher product prices. Increases in prices at the pumps in America have become a hot political issue in the US, especially as this is a presidential election year.

How big a factor is China?

China has not suddenly come on the scene but its importance in the world economy - in 2002 and 2003 it accounted for one-third of global economic growth - has led to an increased focus on current and future oil demand from the world's most populous nation.

In 15 years Chinese oil demand has gone from 2.0 million barrels a day to 5.5 million, its share of world demand doubling to 7 per cent. China's strong economic growth, more than 9 per cent last year, suggests this demand will continue to rise rapidly.

Does Opec (the Organisation of Oil Producing Countries) still control oil prices?

Not on the basis of recent evidence. Opec's target range for oil prices is $22 to $28 a barrel. Its members have expressed concern that higher prices will be destabilising for the oil market. In the past, big rises in oil prices have been followed by sharp slumps to $10 a barrel or below.

Opec is not, however, helping to peg back prices. The International Energy Agency said this week that Opec is not producing to its agreed quotas, with underproduction equivalent to about 2.5 million barrels a day, about half of that in Saudi Arabia. Opec's next scheduled meeting to review supply is in Beirut on June 3.

Will higher oil prices push us into recession?

In the past, economists pointed to a close relationship between higher oil prices and global recession. Western countries have, however, reduced their sensitivity to oil as their economies have become more service-based. The OECD, the Paris-based organisation for the advanced economies, says that dearer oil could knock up to 0.5 per cent off world growth this year and next, if sustained. But this is in the context of a 4 per cent growth rate for the world economy as a whole.

What about inflation?

Higher petrol prices are very visible but, given that three-quarters of the price is tax, the effect of higher crude prices is not as big as it could be. Higher prices add to industry's costs and push the consumer prices index up directly. But the Bank of England will get worried only if there is evidence that dearer oil is feeding through into higher prices and wages more generally, so called "second round" effects.

Are higher oil prices bad for the stock market?

Yes. Apart from some limited benefit for oil companies, the effect on most firms will be a rise in costs which they may or may not be able to pass on the customers. If they can, they will contribute to an environment in which central banks are forced to raise interest rates and thus curb economic growth. If they can't pass them on, their proifits will be squeezed. Either way, investors are unlikely to gain.

From The Times/Sunday Times website