Sunday, June 03, 2007
Opec still has us over a barrel
Posted by David Smith at 08:59 AM
Category: David Smith's other articles


It takes a plucky writer to admit he is wrong, particularly when there is a certain type of reader out there – usually anonymous, sometimes using joined-up writing – who is happy to tell me I am wrong every week.

But I have been wrong, so far at least, on oil. High oil prices, one of the factors that have complicated the task of the Bank of England and its fellow central banks, are still with us, having climbed back above $70 a barrel in recent weeks. Last week they remained close to that level. Futures markets suggest $60-$70-a-barrel oil for the foreseeable future.

My hopes were raised earlier this year when prices dipped briefly below $50 a barrel, not far above the $40 level I had said was sustainable in the long-term. But the market was just teasing, and prices were soon on their way back up again.

So this is a good time to revisit oil, and to ask the question: Will prices ever come down again?

America’s “driving season”, which traditionally begins on Memorial Day (last Monday), is a key date in the oil season. Last summer, high prices had the effect of curbing so-called VMT (vehicle miles travelled) in America and prevented the usual seasonal rise in demand that occurs as the weather warms up.

With petrol prices having spiked higher again, something similar may be in store. Higher prices do have an effect – American carbon emissions fell last year.

So what has been pushing up oil prices? International tension, whether it be the Iraqi insurgency, violence in Lebanon or Gaza or American warships patrolling off Iran, appears to be ever-present.

With 62% of the world’s “proved” oil reserves in the Middle East, this is an uncomfortable backdrop. Tensions in the region are worth, on reasonable estimates, $10-$15 of the current price of crude oil, maybe more. The big one, of course, would be a serious Saudi insurgency, with attacks on the world’s biggest producer’s oil installations. Some attacks have been thwarted by the kingdom’s security services this year.

Tension in the Middle East is one thing but turbulence in Africa has had a more direct effect on oil output. Political unrest around Nigeria’s presidential election and the activities of militants in the Niger Delta, who specialise in kidnapping oil workers, have combined with technical problems to cut production, at times by 800,000 barrels a day, though a strike was called off last weekend.

There are other important factors. One reason American motorists are starting the driving season with petrol prices of well over $3 a gallon (40p a litre) is the high price of crude. But equally important is the chronic shortage of American refinery capacity. No new refineries have been built since the 1970s and the oil giants have been fighting congressional allegations of “price-gouging”, in other words profiteering.

These are all important factors, and there are others. Hedge funds moved money out of oil earlier in the year but have come back in. Investment demand has helped to boost prices.

The two most important reasons for the strength of oil prices, however, lie elsewhere. The first is the strength of the global economy. More than a year ago, the International Monetary Fund (IMF) spoke of an “extraordinary purple patch” for the world economy. At that time the global economy was enjoying its third successive year of roughly 5% growth, its best run since the early 1970s.

The thing about purple patches is that they tend to be temporary. My expectation of softer oil prices was partly based on a softening of global growth, perhaps only to 4% but enough to make a significant dent in oil demand.

But that has not happened, despite weaker growth in America. The world is still growing at 5%, for the fourth year in a row, and forecasts from the IMF and OECD suggest something like this will continue next year and even beyond it. World economic growth of 5% does not mean a 5% rise in global oil demand but, according to the International Energy Agency (IEA), it does mean a rise of 1.8% this year, after 1.3% last year. The global economy would need to slow to below 4% to flatten oil demand. That is possible at some stage, but for the moment there is plenty of momentum. Some oil-price bulls, curiously, were growth bears, which never looked very rational.

Demand is one factor, supply the other, and here the finger has to be pointed firmly at the Organisation of Petroleum Exporting Countries (Opec). The cartel has got its act together, cutting production, ostensibly to put a $60-a-barrel floor under prices, in practice to keep prices well above that.

The IEA estimates that Opec production, at just over 30m barrels a day, is 3.7m barrels below its sustainable capacity. Four years ago Opec was happy to keep oil prices in a $22-$28 range. Then it said it wanted to protect $50; soon it could be more than $60.

Is Opec, dominated by the Arab oil states, being greedy? Yes. I wish I could say they would suffer for it. But as long as the world economy is strong, evidence of “demand destruction” – collapse in demand for oil that would push down prices – is hard to detect. Some Opec members would no doubt blame western intervention in the Middle East for high prices.

So what will happen? There are three possibilities. One is that it is onwards and upwards for prices, each increase in international tension interacting with tight supply to push us to $80, $100 or beyond. The other is that $60-$70 is the new sustainable level and that, as the futures markets imply, we will stay there for some time. The third possibility is that prices will drop significantly again.

I would still argue, based on the history, that this is too high and that at some stage, as has always happened in the past, prices will drop significantly again. But some oil price spikes are short, no more than a year or two. Some last longer. You could argue that we were in a continuous spike from 1973 to 1985. This one is getting longer by the day. Until demand weakens, it will continue.

PS: How worried should we be about a “back to back” rate rise from the Bank of England this week? We have been warned by both the Bank’s latest inflation report and the minutes of its May meeting that at least one further rise is on the way. Those interested in historical parallels will note that the last time it happened was exactly three years ago, in May and June of 2004.

The minutes suggested the reason nobody on the monetary policy committee (MPC) voted for a half-point rise last month was because even those members who toyed with it were unconvinced and wanted time to assess the effect of rate rises so far. Other members stressed the need to move cautiously on rates, while a third group was concerned about triggering a downturn in the economy. None of this suggested much of an appetite to move again quickly, though people’s perspectives change, even over a month.

The “shadow” MPC, which meets under the auspices of the Institute of Economic Affairs, has also been deliberating. It has been more aggressive than the actual MPC, four of its members urging a half-point rise last month.

This time, the shadow MPC has one “half-pointer”, the former dove Roger Bootle, who thinks the shock therapy of an immediate move to 6% is needed because “the stakes are too high to be pussy footing”. Three other members of the committee – Tim Congdon, Andrew Lilico and my namesake David B Smith – all want a quarter-point hike this week.

Bootle said there is a danger inflation will get out of control. Congdon now believes the likely peak in rates will be 6.5%, attacking the Bank’s analysis of the relationship between the money supply and asset price inflation as “useless”.

These four were, however, outvoted by five others, Kent Matthews, Patrick Minford, Peter Spencer, Peter Warburton and Trevor Williams. Even if they are right this week, however, the Bank will still have to hike again – all four of the hikers and two of the “holders”, Spencer and Williams, have a bias towards further tightening.

From The Sunday Times, June 3 2007


Couple of points on Oil:

1. In the short term, there is a big chance of another disruption in the Gulf of Mexico this year because of the hurricane season. I think the prediction is something like 70% (but last year they said 80%, and it didn't happen, so make of that what you will).

2. One for the long term now: Crude production in Saudi Arabia declined 8% last year. In what seemed like a time of temporary price strength, it doesn't make sense that ALL the 8% was due to OPEC quota cuts. Other large oil fields have shown declines of 2-3% per year once they've passed their peak production, and there is growing evidence to suggest that Ghawar now falls into this category. So maybe some of the 8% decline is due to OPEC quotas, but that masks the real story that SA has passed peak.

3. On the refineries, the big oil companies have simply not put the investment into their infrastructure which is now decaying. It has also been running at very high capacity allowing no time for routine maintenance, but they have not sought to increase capacity. These two facts speak volumes about their long term view of production levels at refineries. They know that production of petroleum from crude oil is about to head into irreversible decline, so why put the investment in? The 90% capacity is temporarily inconvenient and delays maintenance, but soon it will be back down to 80% so the maintenance can be done (then 70%, 60%, etc etc).

The big question of course is how high prices (of crude and consumer fuels) will have to go before demand destruction can match production declines. Nobody knows, but I would not like to bet on it being anything other than "high"!

Posted by: Minh at June 3, 2007 10:27 AM

To err is human David. I don't really think anyone expects that you have perfect predictive powers. But to admit to ones mistakes is certainly noble.

Posted by: Jason Borr at June 3, 2007 02:22 PM

Dear David,
The conversation about oil always gets serious and sometimes very heated. To add another (more amusing?) dimension, in a recent paper,
we find strong evidence for the widespread
presence of “fuel tourism” and its impact on asymmetries in price transmission; the drivers in high-tax countries tend to travel to neighbouring low-tax countries reaping the price differentials, thus contributing to the demand abroad.
Pity that we need to go through the fuss of crossing the channel and fill up..
Many thanks

Posted by: Costas Milas at June 3, 2007 05:50 PM
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