Oil & gas: how high can prices go? A report researched and written by international economic analyst Moin Siddiqi

Middle East, The, June, 2008 by Moin Siddiqi

THE INEXORABLE SURGE in crude oil prices from below $70/ barrel last August defies the conventional wisdom that says prices will drop when global economic activity slows and energy demand decelerates. According to the International Monetary Fund (IMF), "The world economy has entered new and precarious territory." The energy-guzzling nations of the Organisation for Economic Cooperation and Development (OECD)--and especially the US--are suffering growth slowdown or mild recession. The latest World Economic Outlook report projects the US economy (largest oil consumer) dipping into a recession in the first half of this year and at best growing at a parry 0.5% in 2008, while the eurozone and Japan are both expected to grow by just 1.4%. In all, global growth could slow markedly, from 4.9% last year to 3.7% in 2008. The London based Capital Economics commented: "Given the clear deterioration in the outlook for demand, it is hard to escape the conclusion that oil prices are rising well above levels that can be explained by the usual economic fundamentals."

Strangely the oil markets are hitting new heights in a world of credit crunch and genuine fears of recession. On 9 May 2008, the US benchmark West Texas Intermediate reached $126/barrel, while Brent blend (European benchmark) hit a new high of $125.6. More significantly, in real (inflation-adjusted) terms, crude in today's money has surpassed its previous peak of $102.5 in April 1980 at the start of the Iraq-Iran war. Not surprisingly, the Arab dominated Opec-cartel, responsible for two-thirds of world exports, is enjoying resurgence and hefty windfalls. The US Energy Information Administration (EIA), the statistical arm of the US Energy Department, estimates that 13 Opec members should earn a record $1 trillion this year in net oil revenues, a jump of 57% from last year's $674bn. Saudi Arabia, the world's No. 1 producer, will account for a third of the total, whereas a decade ago, total Opec revenues plunged to $110bn with oil selling at an amazing low of $10/barrel. At triple-digit crude price, the total proved reserves of oil-exporters (including non-Opec countries) are calculated to be worth $104 trillion, of which about $48 trillion belongs to Gulf Co-operation Council (GCC) producers--Saudi Arabia, the UAE, Bahrain, Kuwait, Qatar and Oman.

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Barclays Capital, a UK investment bank, thinks: "The headline $100 is very interesting. What is more interesting is what is happening to longer-term prices and annual average." Oil averaged $31.5/barrel in 2003, $41.5 in 2004, $56.7 in 2005 and $66.2 in 2006. Upward momentum continued into 2007, with $73.5/barrel. The 2008 average will certainly exceed last year's figure. The West's energy watchdog, the International Energy Agency (IEA), warned that the lower-level price age might have ended, "with a move into an era of very high-energy prices". We should get used to more expensive fuel over the next decade.

What reasons lie behind this 'over-heated' market and where does the blame lie?

'Hyperinflation' in oil prices has been underpinned by fears about future supplies, inventory shortfalls and refining bottlenecks in OECD regions. Buoyant Asian demand (led by China and India) and supply disruptions in Nigeria and recently the North Sea have exacerbated the situation. Meanwhile, geo-political tensions in the Middle East (sitting on two-thirds of the world's proved oil reserves or 800bn barrels), speculative money seeking 'alternative' investments away from bearish equity markets coupled with an embattled dollar hit by a bout of grim US economic news and interest rate cuts (now 2%) also fuelled the recent price boom.

A sliding dollar makes it cheaper for foreign buyers to invest in commodities, which are priced in US dollars. Purvin & Gertz, energy consultants, said: "We have got a confluence of a number of events that have really disrupted crude oil supply and that's what's driving oil to a new record."

Market assessments of Opec and IEA are noticeably different. The latter thinks speculation is not the sole cause but tightening balances between supply/demand explain runaway prices. It argues current levels of global spare capacity and inventories are quite fragile. Oil stocks measured as a proportion of daily consumption in OECD economies were estimated at 53 days in March 2008, with total industry stocks at 2,583m barrels, on IEA figures. The French bank BNP Paribas agrees with IEA by saying: "The supply buffer remains thin in view of robust demand growth in emerging markets, geopolitical risks and declining production in mature fields." In a separate report, the Centre for Global Energy Studies (CGES) noted: "The world needs Opec to err on the side of overproduction, not output restraint, if oil prices are to be brought down."

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Opec, however, maintains there is no supply crunch but rather speculative buying, sinking dollar and geopolitical fears that have led to exaggerated prices. It estimates that up to $30 of today's price is explained by non-fundamental factors and if the dollar falls 1%, the oil price rises by $4/barrel. Opec's secretary-general, Abdullah Al Badri, said: "There is a disconnect ... between price and fundamentals. The market is really influenced by other factors." Moreover, Opec insists that global stocks remain adequate, though refining bottlenecks are being reflected in low product inventories (including heating oil) rather than shortages of crude.