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Wednesday, Jun 02, 2004

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Is an oil peak upon the world?

J. Srinivasan

IS ANOTHER oil shock in the making? All indications point to that considering the rise in world crude prices, not just in the spot market, but also in the futures segment. In the past, the rise in the spot price of crude as, for instance, ahead of both the Gulf wars, was not accompanied by a sympathetic jump in the forward price simply because the market expected the spike to be short-lived. But, this time, the forward price has been going up sharply.

Crude oil has jumped 13 per cent in three weeks. Oil for July delivery reached a record $41.85 a barrel on the New York Mercantile Exchange on May 21, the highest close in the 21-year history of the oil contract. (It then settled at $39.50.) Spot prices reached an all-time high of $41.56 a barrel during the session. Oil has risen 42 per cent in a year.

The biggest worry of any runaway oil price hike is the sustainability of the world economy, and Goldman Sachs has already revised downwards its global economic growth forecast to 3.8 per cent this year from its earlier expectation of 4.6 per cent.

Princeton University professor of economics Alan Krueger, writes in The New York Times that sharp increases in the price of oil preceded four of the last five recessions. "The correlation between the real price of crude oil in a quarter and the unemployment rate a year later is a robust 0.72, according to a study by Alan A. Carruth of the University of Kent, Mark A. Hooker of State Street Global Advisors in London and Andrew J. Oswald of Warwick University. He quotes Prof Oswald thus: `Oil price spikes are probably as close as we get to world laboratory experiments in macroeconomics'."

Crude price rise certainly impacts economic growth because it has the effect of a tax on the consumer. If people pay more for petrol/diesel, they will have less to spend on other things. Other than directly affecting the consumer, costlier crude also means costlier petro-products which, in turn, make goods made out of them pricier.

With input costs rising for manufacturers commodity prices go up and with it the inflationary expectations. According to Standard & Poor's David Wyss, chief economist, and Beth Ann Bovino, a senior economist, crude oil prices have risen by about $10 a barrel from last year. If that increase were to sustain for a year, it would result in a 0.25 per cent decrease in GDP growth for the year. "We expect the energy price spike to reduce consumer spending by about $50 billion."

One reason for the rise in crude prices is the fall of the dollar, the currency in which oil is denominated. As the Buttonwood column in The Economist says: "Many think that this is one reason why OPEC (Organisation of Petroleum Exporting Countries) is happy to see the oil price remain higher than its self-imposed band of $22-28."

The two other major causes for the price rise are the rising consumption, mainly by China, and speculation. China's rapidly growing economy will account for 40 per cent of the 1.65 million-barrels-a-day increase in demand expected this year by the International Energy Agency.

Last year, China overtook Japan as the second-largest consumer of oil after America. Though the `China factor' did have some psychological influence upon the market, speculation did even more. According to a Xinhua report, China's oil demand rose 8-10 per cent annually since 2003 to 2004 compared to the 6.5-per cent increase from 1992 to 2002, but this was offset by lower demand from European and Latin American countries due to the slow economic recovery.

Also, Wall Street speculators had started to buy in great amount oil and gas futures from September 2003. In the oil futures market, the proportion of speculative for-profit hedge fund has exceeded 20 per cent. Meanwhile, the oil price rise pushed up gas prices which, in turn, drew up the oil price, encouraged by speculators, thus making the bubble bigger and bigger.

The Xinhua report said that "one would not feel hard to explain the problem just by making clear who is benefiting from price hike. Aside from the hedge fund, the oil refining and processing companies are also the biggest gainers from the oil price hike this time... When the price is around $40 per barrel, processing companies can earn $7.26 out of each barrel." Fears are that speculative investment funds will stay long in oil, and wait to see sure signs of key consumer economies stocking up before relaxing their bet on continued oil strength.

Besides China, there are other oil guzzlers in Asia, such as India, which are consuming more what with their economies expanding. According to the Institute of Energy Economics in Japan, the demand from the rest of Asia (excluding Japan) grew by 5.2 per cent to 8.1 million barrels a day. By 2020, Asian oil consumption will rise to 35 million barrels a day.

The other demand-side pressures include the motoring season in the US. With Americans taking to the roads in ever-greater numbers for summer holidays, despite record-high pump prices, inventories would be under pressure and the cost of petrol, already around 25 per cent above last year's peak, would keep the heat on crude prices.

Usually, US petrol inventories rise in April-May as refiners step up production to meet peak summer demand. But, according to the US Energy Department, supplies dropped 1.5 million barrels to 202.5 million in the week ended May 7.

The supply-side pressure is most notably of OPEC cutting production by one million barrels a day. Ironically, Saudi Arabia, the world oil industry's swing producer, which had wanted the oil cartel to cut production fearing a price crash, now wants OPEC to raise quotas, by at least 1.5 million barrels per day, with its fears on prices negated.

In fact, Saudi Arabia has made a unilateral commitment to pump 9.1 million barrels per day (bpd) in June — about 800,000 barrels more than its April production, and over 1.4 million barrels more than its official OPEC quota of 7.638 million bpd.

At the next OPEC meeting, on June 3, Saudi Arabia's Oil Minister, Mr Ali al-Naimi, is expected to pitch for the cartel raising output from 23.5m bpd to 26m bpd.

According to Bloomberg data, OPEC's 11 members had 3.5m bpd of spare production capacity in April. Saudi Arabia, the world's biggest oil exporter, can boost output by 1.65m bpd. West Asian producers pump almost 30 per cent of the world's oil but consume just over 5 per cent, making them the main source of exports. The region holds almost two-thirds of proved global reserves.

But not every OPEC member is as keen to pump more oil, simply because most, including Libya and Venezuela, are already producing close to full capacity. Enhanced quotas would mean little to them. It would simply legitimise Saudi Arabia's over-production, leaving others selling no more than before, for a lower price.

Some in the cartel are not going along with Saudi Arabia convinced as they are that the current oil price hike is entirely due to speculation, with traders exploiting the rising summer demand and stretched supplies. Once this bubble bursts, they are sure, prices will collapse.

On the other hand, some other OPEC members want the world to get used to higher prices. They point to the insecurity that is inhibiting investment in under-exploited West Asian oilfields, and to the strong demand from China, and India, which spent some $15 billion on its oil imports last year. "The history of cheap oil may have ended," Financial Times quoted Mr Rafael Ramirez, Venezuela's Energy Minister, as saying.

Washington may, however, manage to keep Riyadh on line while other G-7 nations convince the rest of the cartel not to make much noise about Saudi Arabia raising production.

The other positives are that OPEC's second biggest producer, Iran, has said it wants to raise supply limits though it has not yet backed the Saudi proposal. Mexico, the world's eighth-largest oil exporter, said it would boost crude exports to 1.95m bpd this year, up from 1.88m bpd.

Also, Russia has said it would try to raise oil exports, though it is suspected that it is simply to take advantage of high world market prices. Its Industry and Energy Ministry has said Russia's crude oil exports to countries outside the 12 Commonwealth of Independent States in the first three months of 2004 soared to 43.24 million tonnes or 3.46 million barrels a day, up 23 per cent over the 2003 period.

So is it another oil shock? Apparently not, or at least not yet. To quote the Buttonwood column (in The Economist): "... Many argue that the latest jump in oil prices is far more modest than it was in the two oil shocks of the 1970s. In real terms — that is, adjusted for inflation — the price is still a lot lower than it was then. Rich countries are, moreover, far less dependent on oil than they were, because they have become more efficient at making things, and anyway make fewer of them. And the rise in the oil price, as measured in anything other than the beleaguered dollar, has been comparatively trifling... "

Some economists believe that oil prices will soften in the months ahead, and say the recent sharp jump needs to be kept in perspective. The price of nearly $42 per barrel was surely a record in current dollars. But, after adjusting for inflation, the prices are far lower than the peaks during the previous crises. In today's dollars, oil hit a peak of around $80 per barrel in the early 1980s and petrol sold for the equivalent of $2.85 a gallon (it now sells at $2-plus) in the US.

So, where does all this leave the world economy? Perhaps, it is true that the world should forget the era of low prices, and get used to the idea of optimising its use.

Tim Appenzeller, writing in National Geographic, sums it up aptly when he says that: "Slaking the world's oil thirst is harder than it used to be. The old sources can't be counted on anymore. On land the lower 48 states of the US are tapped out, producing less than half the oil they did at their peak in 1970. Production from the North Slope of Alaska and the North Sea of Europe, burgeoning oil regions 20 years ago, is in decline. Unrest in Venezuela and Nigeria threatens the flow of oil. The Middle East remains the mother lode of crude, but war and instability underscore the perils of depending on that region...

"And so oil companies are searching for new supplies and braving high costs, both human and economic... But in the end the quest for more cheap oil will prove a losing game: Not just because oil consumption imposes severe costs on the environment, health, and taxpayers, but also because the world's oil addiction is hastening a day of reckoning.

"Humanity's way of life is on a collision course with geology — with the stark fact that the Earth holds a finite supply of oil. The flood of crude from fields around the world will ultimately top out, then dwindle. It could be five years from now or 30: No one knows for sure, and geologists and economists are embroiled in debate about just when the `oil peak' will be upon us. But few doubt that it is coming."

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