Monday, April 25, 2005
Over a $105 barrel
Posted by David Smith at 07:00 PM
Category: David Smith' s magazine articles

One of the most striking developments in the global economy, with direct effects on businesses and consumers everywhere, has been the performance of oil prices. As I write this the price of crude in New York is nudging $60 a barrel and this, I am happy to acknowledge, is not something I had expected. There may yet be worse to come.

A plausible story about oil prices, indeed one I have told here, was that they would spike higher during the invasion of Iraq two years ago, but subside pretty quickly afterwards. This, after all, was precisely what happened during and after the first Gulf war. Then, oil prices rose when Saddam Hussein invaded Kuwait in the summer of 1990, but fell back sharply after the allied victory in early 1991.

Even when this did not happen in 2003, it was possible to argue that this was just a delay. The security situation in Iraq, the insurgency, had made it hard to lift oil output and cast a shadow over prospects for oil supplies elsewhere in the region. But the return to normality, surely, was only a matter of time.

Now, however, we have to recognise a rather different reality. Iraq, it seems, was a red herring in the oil story. While it raised some short-term questions over global oil supplies, the real action was on the other side of the equation – the rise in demand for the precious black stuff.

It is this new reality that recently prompted Goldman Sachs, the investment bank, to come up with the eye-catching suggestion that crude could hit $105 a barrel. That, to put it in perspective, is four times the official $22 to $28 a barrel target range the Organisation of Petroleum Exporting Countries had ahead of the Iraq war.

Goldman Sachs, it should be said, is not predicting that oil prices will stay at $100 a barrel plus. Their forecast was for a “spike”, in other words a temporary move, in prices to this level. In certain circumstances, they warn, that spike could see prices as high as $135. But even the Goldman forecast of longer-term sustainable prices offers little comfort. It predicts an average of $50 a barrel for US crude (so-called West Texas intermediate) this year, rising to $55 a barrel next. What happened to the prospect of a new cheap oil era?

Nor, it should be said, is this an ivory tower forecast. Goldman Sachs is one of the biggest traders in energy derivatives and knows the market well. That does not mean their forecasts will be right; it does mean it comes from a position of some knowledge.

Why are prices so high? We all know the China story, and rising demand from the world’s fastest growing big economy. This remains important, and is the single biggest reason for the tightness of the supply-demand equation in recent years. At current (and rising) levels of demand from China, there is very little spare supply capacity in the world, despite efforts by the OPEC to dampen down prices.

But China is not alone. An important part of the Goldman Sachs forecast is that prices have not yet risen by enough to bring about a cut in demand in America. American motorists changed their driving habits (and the size of their cars) after the two oil shocks of the 1970s. Then, spending on gasoline reached 4.5 per cent of gross domestic product, or 6.2 per cent of personal disposable income. This time, even if we get to $105 temporarily, and stay in $50 a barrel plus territory, the equivalent figures are 3.6 per cent of GDP and 5 per cent of personal disposable income. It could take a spike to $135 a barrel to persuade US motorists to part with their gas-guzzling giant SUVs (sports utility vehicles).

What will be the consequences for the economy and industry of, say, long-term $50-60 a barrel oil prices? Despite some signs that inflation is re-emerging, notably in America, the biggest impact of dearer oil is likely to be on growth, not prices. The proper way of looking at high oil prices is as a tax levied by the producing nations on consuming countries. Like tax, high prices are not something that consumers can avoid.

Britain is relatively well placed compared with other industrial countries, not just because of North Sea oil (though output is in decline) but also because the UK economy is less oil-dependent than America and most EU economies. Some of that, sadly, has to do with our relatively small manufacturing sector.

That is little comfort to energy-intensive sectors, which will bear the brunt of the price rise. I do not think it is going to tip the world into recession but it is not going to be comfortable. Dear oil, it now seems, is here to stay.

From The Manufacturer, April 2005


"Goldman Sachs is one of the biggest traders in energy derivatives"

This fact tells us that Goldman Sachs has a vested interest in market volatility.

What amazes me is that when the oil price rises by a significant amount in a day then a rash of pundits appear to justify this change in terms of “fears” over supply. And yet there has been no failure of supply – years of wars, hurricanes, refinery explosions but no rationing at the petrol pump.

Even if there might be a problem in a few years’ time that’s no reason for the price of oil for delivery in three months’ time to rise.

Surely the obvious explanation for the high oil price and high price-volatility is speculation by the likes of Goldman Sachs and other US-based speculators.

There’s no difference between today’s commodity speculation and the Asian currency speculation of the 90s. It’s driven by a ready supply of vast amounts of cheap money being put on what’s seen as a one-way bet in a restricted market. To describe this as “free market forces” is ridiculous.

Just as governments take steps to stop disruptive speculation in currency and equity markets, the oil market is too important to be left to manipulation by speculators. The US government could make oil price speculation unprofitable but it doesn’t, for reasons that seem all too obvious.

Posted by: David Sandiford at April 26, 2005 06:51 AM

I too echo the comments of the previous poster. The Economist is simply accepting the rhetoric of such biased companies. I've seen elsewhere that while world energy demand is up, the overall demand is not more than 5%, so these skyrocketing prices are indeed part of the speculation, something stated by Asian financial analysts over a year ago, so perhaps if the media would do its job maybe the truth of such biased allegations made by Goldman's could be vetted.

Posted by: ron rivers at June 13, 2005 09:17 PM