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 IEA has forecast that demand growth will accelerate this year by 1.2m b/d or 1.4% over 2007. World oil usage is expected to average 87.2m b/d. Vigorous growth and fuel subsidies in China, India and the Middle East will underpin demand, thus offsetting weak consumption in OECD regions. Overall, non-OECD demand is predicted to reach 38.2m b/d, up 3.6% on last year. In developed markets the 'oil intensity' of gross domestic product (GDP)--amount of oil needed for each unit of output--has fallen sharply since the 1970s. Hence, oil now constitutes a smaller share of GDP in the US, western Europe and Japan.

Sustained over-inflated prices will encourage investment in alternative forms of energy like nuclear power, liquefied natural gas, biofuels, gas-to-liquids and greater energy efficiency to lower reliance on petroleum. Last year, President George Bush signed a new bill to increase fuel efficiency standards for US manufactured cars to 35 miles per gallon by 2020. The IEA thinks: "The $100 price is a strong reminder that consumers and governments have to implement measures that improve energy efficiency. Such measures are available now and provide the most effective short-term responses. In the longer term, greater investment in the upstream and downstream sectors is needed. More broadly, consumer countries must also increase investment in alternative energy sources."

How high crude will go in current market sentiment is anyone's guess. Opec's president recently spoke of $200 oil that would kill off demand and increase the severity of a global recession. The evidence suggests that markets are moving into a new phase--setting a much higher floor compared to recent years. The Washington-based consultancy, PFC Energy, explained that oil-producers now require massive (revenue) flows, which are only possible with robust prices. "This is one of the factors leading to long-term higher prices," said PFC.

The crude futures market is very buoyant, reflected in higher long-dated prices. Traders are betting on sustained robust demand (especially in China) and weak supply responses for years to come due to low exploration and development spending and oil nationalisation in Saudi Arabia, Iran, Venezuela and Mexico, which ban foreign investment in upstream sectors. Acclaimed investor Jim Rogers said: "There has been no major oil discovery for the last 40 years and all the major reserves are in decline. By 2018 or 2019, we could get to $200 or $300/barrel." Goldman Sachs thinks a need for further investments will result in explosive prices over the next two years potentially spiking towards $200. Standard Chartered projects oil at $150 a barrel within three to five years.

Having looked at various reasons behind extreme price volatility, it's fair to conclude that the oil market is divorced from fundamentals. It resembles the past boom in dotcom shares and property prices As one analyst put it: "It's like the dotcom boom in the 1990s. It was over-inflated, but as long as everyone kept believing in it, the price went up. When they stopped believing in it, the price went down. And that's a warning." As financial market conditions improve and the dollar recovers, outflows of speculative money could lead to a potentially sharp correction to the $70-$85/barrel range by end-year or early 2009. A note of caution: Crude oil predictions have proved unreliable in recent years. In the medium-term, extra supply outside the Opec (notably from Azerbaijan, Brazil, Canada and Kazakhstan), planned additions to Opec capacity and from unconventional sources like oil sands and coal to oil should provide ingredients for softening crude markets. Rising supply and moderating energy usage in OECD regions mean lower prices. That said, the era of cheap energy is over. Pointing to cost inflation [labour, capital and materials], the IEA reckons the oil industry is "preparing for a sustained $60-$80/barrel world". Runaway prices, if sustained, can inflict severe damages upon both consumers and producers. The CGES warned: "They [Opec-cartel] seem to believe that the world can live with $100 oil ... But this will ultimately drive the search for alternative forms of energy and greater efficiency." The interest of Gulf producers lies in moderate prices that support global economy and by extension higher oil demand.