Sunday, January 15, 2006
Oil prices are gushing but could soon plunge
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

Of all the hurdles to be negotiated by the economy this year, one of the most interesting will be that of high oil prices. Last year, no matter how hard you looked, it was difficult to detect much of an oil-price effect on the world economy, though Gordon Brown blamed it for some of Britain’s slowdown. It was, as I wrote in September, a dog that didn’t bark.

But now some interesting dilemmas are emerging. After the price per barrel of crude fell towards the end of last year into the mid-$50s, from a Hurricane Katrina peak of $70, they have crept up again. An oil price in the low to mid $60s appears to be the new norm, and it would not take much of a supply or weather shock to push it back up to or beyond last August’s record. Forecourt prices for petrol, as some will have spotted, have edged higher.

The dilemmas are these. If global growth does not slow, and it is put at a robust 4.2% this year by Goldman Sachs, does this mean sky-high oil prices are here to stay? Could it be the promise of extra oil supplies to dampen down prices will turn out to be a mirage, particularly now members of Opec (the Organisation of Petroleum Exporting Countries) seem happy with a high crude price?

There is, on top of this, a longer-term dilemma. Even those who were previously sceptical are convinced climate change is occurring; the only questions are of degree, and the extent to which it is all man-made. Part of the economic solution to climate change is that demand slows in response to high prices. If it doesn’t we could be in more trouble than we think.

The historical backdrop to the current oil price, which I have drawn comfort from before, is as follows. We have data on oil prices dating back to the early 1860s. In inflation-adjusted terms oil has risen above $40 a barrel relatively rarely and not stayed there for long.

Dr Leo Drollas, chief economist at the Centre for Global Energy Studies (CGES), points out that the history can be split into two distinct periods. Up to 1973 the average price in 2005 dollars was around $20 a barrel. Since Opec first exercised its power that year and the world entered an era of high inflation and economic turbulence the average has been nearer $40.

Could it be we are now in a third leg of the oil story and $60 will become the new benchmark? Not only is the global economy robust but it is tilting towards economies like China and India with a higher energy intensity and powerful economic growth. Meanwhile there is no sign of demand restraint in energy-greedy America. Even here, the fifth successive monthly trade deficit in oil announced last week was testimony, not only to the North Sea’s decline as an oil province, but also strong UK oil demand.

Tie that in to supply worries - will the attempt to clamp down on Iran’s nuclear ambitions result in that country cutting off oil exports? - and it seems there is a high-price cocktail. Iran produces 5% of the world's oil. Cut that off and the price could hit $100. Nor, some argue, are these supply concerns temporary.

Last week the UK Society of Investment Professionals ran a debate on the question: Has oil production peaked?

Speaking for the motion was Jeremy Leggett, author of Half Gone: Oil, Gas, Hot Air and the Global Energy Crisis (Portobello Books). He argued that worldwide oil production is about to hit a plateau and produced an impressive array of statistics.

The world’s biggest oilfields, the giant Saudi and Kuwaiti fields, were discovered as long ago as the 1930s and 1940s. The year in which most oil was discovered in the world was as long ago as 1965. The last major oil province to be discovered was the North Sea in the 1970s. The last year in which more new oil was discovered than was being used annually was 25 years ago.

Leggett, a geologist by background, argued that the world’s oil production peak will be reached in 2008, plus or minus two years. He has, in addition, put his career where his mouth is, as chief executive of Solar Century, which claims to be Britain’s leading solar photovolatics company (producing energy from sunlight).

Against him was the CGES’s Drollas. He took the view that the peak in conventional oil production is still some way off, probably around 2022, ands that if you add unconventional oil to the equation - oil from tar sands, shale and so on - it will be well after that. The world has plenty of oil reserves; the key question is how prepared the producers are to allowing them to be exploited.

Saudi Arabia, for example, which could pump more crude now and bring the price down, appears to have shifted its stance from doing its utmost to keep the oil price down at sustainable levels to enjoying high prices while they last. Its ageing leadership appears to have become more short-termist in outlook, the domestic political benefits of exploiting high prices being worth more than international diplomacy.

So where does that leave prices? Drollas’s view is that there will be serious “demand destruction” at $60-a-barrel plus oil, in other words demand will slow sharply, and that Opec’s challenge for this year will be preventing a drop in prices to significantly below $50. The large speculative element in oil futures trading means any price reversal could be dramatic.

BP, like Drollas, argues that it is too soon for there to have been a serious demand effect. Oil demand is inelastic but only in the short-term. It does not take too long before high prices change behaviour. Meanwhile, high prices will also bring forward extra supply. Non-Opec supplies from areas like the former Soviet Union and Africa will rise by at least 1m barrels a day this year.

The Paris-based International Energy Agency which will release new oil market forecasts this week, is upbeat about demand prospects. Drollas is much more downbeat - believing even if the world economy grows robustly it will economise on its use of oil.

I still believe, looking at the history, that not enough has changed to shift us into an era of $60 a barrel-plus oil. I think that we will head back below $40. But the path to lower prices won’t be a smooth one.

PS We won’t know until this Friday what the official statisticians’ verdict is on Christmas spending but according to the British Retail Consortium stores had a riproaring time. The BRC, which not long ago was warning that a high street slowdown was leading the economy into recession, reported that total sales value last month was 6.2% up on a year earlier. On the “like for like” measure retailers favour - it reflects their expansion of floorspace - sales rose by 2.6%.

We shouldn’t assume this means the official retail sales measure this week will be up strongly; on past form it could show a fall. The BRC itself has made the point that there hasn’t been much post-Christmas follow-through in spending. But the numbers were much stronger than anybody had expected.

What does the evidence so far tell us about the prospect of a February rate cut? The housing market is picking up, with approvals and prices stronger in the past couple of months. The weakness of consumer spending feared by some members of the monetary policy committee (MPC) is at the very least open to debate. Higher oil prices, discussed above, will hurt short-term inflation prospects. The numbers, then, have been moving against an early cut, as the markets have sensed, though we’ll know a lot more after this week’s barrage of figures.

The other early pointer is that Britain’s economy is not obviously rebalancing. In fact, if November’s £6 billion record deficit in goods - announced last week - is anything to go by, we are heading in the wrong direction. In the first 11 months of 2005 the trade deficit in goods was £58.5 billion, indicating a full year figure of well over £60 billion. That’s more than £1,000 per person. Worrying.

From The Sunday Times, January 15 2006


David I agree that "demand destruction", or at least a serious slowdown in demand growth, is a likely outcome. Indeed in the US, demand has actually fallen in recent months owing to the disruption caused by Hurricanes Katrina and Rita. And in China, oil demand is hardly growing because refiners cannot afford to supply the domestic market. China and the US accounted for half the growth in world demand last year, and there is little scope for growth elsewhere.

Additionally, non-Opec supply should increase this year, making it harder for Opec to defend the price.

But we should not forget that some of the factors driving the oil bull market have not been "solved." Principally, the limitations of global refining capacity. The extraordinary refining margins in the wake of the hurricane season led refiners to run flat out for the remainder of the year, and many have pushed back essential maintenance shutdowns. But there is only so long that refiners can keep the pedal on the floor, before stoppages both planned and unplanned start to happen. As refinery runs return closer to historic and sustainable norms, tightness will again start to be felt in the products markets, with a knock on effect on crude prices (even though it seems to some counterintuitive that crude prices should rise while refineries are running less crude - oil markets are funny in this respect).

Add to this the fact that global production is getting heavier and sourer - which means that it will yield less of the valued light products - and you have a recipe for continued strength.

Posted by: El Pirata at January 16, 2006 10:50 PM

I agree with the comments above. There is more to oil than just oil demand and supply. There are production constraints, complicated by the light/heavy crude issue. There is also the refining constraint. I understand no refining capacity has been added in America or Europe for over 20 years.

The combination of the above, coupled to inelastic demand, political instability in many oil exporters, potential bad weather... oil is an accident waiting to happen. Lower oil prices may have led to inflation falling to 2% in December, but as noted above, petrol prices are rising already, so those interest rate cuts anticipated in Spring may not materialise.

America will change its reserves reporting requirements in July 2006, which will be interesting.

Posted by: David Goldfinch at January 17, 2006 08:35 PM

Very interesting ariticles. Wish to recevice articles from you. Thanks!

Posted by: Irene Ng at January 18, 2006 04:58 AM

It is a question of degree. I don't dispute that the sustainable price of oil has gone up for all the reasons you outline. I do dispute that it has trebled. Three years ago, the sustainable price was thought to be in the low to mid-$20s. If it is going to stay at $60-plus, that's a huge change. Even if $35-40 is the new level, as I believe, that's a big increase.

Posted by: David Smith at January 18, 2006 12:38 PM
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