The real price of oil

Despite predictions that 2006 would see a decline in oil prices a dramatic reversal has occured. But there is still no reason for the world to panic, writes Stephen Corley.

  • E-Mail
By  Stephen Corley Published  August 13, 2006

|~|44-Copy-of-Oil-and-Gas-200.jpg|~|Pump it up: A refinery in Sharjah, UAE, (left) helps to contribute to the country’s US$50 bn yearly income from oil.|~|Despite predictions that 2006 would see a decline in oil prices a dramatic reversal has occured. But there is still no reason for the world to panic, writes Stephen Corley. Despite the well-documented collapse in Arab stock markets – and the domino effect effect on spending – high liquidity from oil revenues looks likely to remain the region’s defining feature for years to come. Meanwhile, of course, the rest of the world is frantically assessing more short-term economic ramifications of price spikes. Yet, although some may wail, oil prices are not breaking all-time records. Nor are they anomalies caused by headline-dominating geopolitical unrest: the violent conflict that continues to engage Israel and Lebanon has, in truth, almost no effects on oil prices, as it presents no genuine threat to supply. Current prices simply reflect another step in the longest upward march in the history of oil trading – indeed, a trend that has dovetailed with perhaps the central issue confronting a generation – as global demand increases for a finite precious resource. Genuine event-driven spikes can be seen by a careful analysis of the history of oil prices. While prices might appear high today compared to any time during the last 35 years, when adjusted for inflation they actually remain far short of the $99 per barrel all-time record of April 1980. In fact, oil traded above today’s real levels from September 1979 to December 1981. According to US Energy Department data, adjusting for inflation, oil exceeded $86 in early 1981, when Iranian production collapsed following the country’s Islamic revolution. It is therefore extremely misleading to portray “all-time highs” while ignoring the tremendous inflationary distortions of the past quarter century. Yes, oil is expensive, but it has certainly been more expensive. The question now on everyone’s lips is: how much more costly will it get in the short term? Jim Rogers, co-founder of George Soros’s Quantum hedge fund, believes that oil prices could reach $100 a barrel within the next five months: “Unless somebody discovers something very quickly and very accessibly, we’re all going to be dumbfounded at how high the price of oil will go, including me,” Rogers recently told journalists in Singapore. The commodities team at Merrill Lynch, the world’s biggest brokerage, apparently disagrees though. Oil supplies would have to stop from a country such as Iran to drive the market higher, its commodities research chief Francisco Blanch told Bloomberg at the tail-end of July. “It’s unlikely we will see another price rally from here,” he predicted, “unless the current conflict expands beyond its current borders. You’d need physical disruptions and large ones, to bring the price to $100.” Cue Iran’s deputy oil minister, Mohammad Hadi Nejad-Hosseinian, who, on a visit to India last week, remarked that international crude oil prices could hit $100 a barrel, driven by political upheaval and an expected winter spike in demand. Yet a growing number of Wall Street traders seem to be agreeing with the investment guru Rogers and the Iranian official. Louise Yamada, of Louise Yamada Technical Research Advisors, said that she expects oil to reach $84 a barrel in the “short term, then keep rising.” Back in July 2004, Yamada predicted that oil would reach $67 within months. Indeed bets on futures contracts for $100 oil tripled in the past three months: the number of options to buy crude at $100 this year stood at 53,047 in late July, triple the amount quoted on 21 April. “Commodity investors looking for $100 oil will see it,” says Philip Verleger, Californian economist and visiting fellow at the Institute for International Economics in Washington. Only a US recession can stop the advance to $100 a barrel before the end of next year, in an echo of similar warnings heard over the last six months ranging from controversial Texan oil analyst Matt Simmons to Sir Bill Gammell, the chief executive of Cairn Energy. Several things flow from sustained higher oil prices. First, substitution becomes a much more attractive proposition. The implications of the long-term bull market in oil are so far-reaching because it currently affects the cost of so much else – travel, heating, agriculture, trade and plastics, etc... But most experts recognise that the age of conventional oil will fade during the next century. Optimists rely on the fact that price and technology will allow for production of heavy oil, tar sands and shale oil, whose combined global reserves far exceed those of conventional oil. The problem with these deposits is that their extraction involves one of the dirtiest processes known to mankind and any progress towards a less oil reliant economy will almost certainly need to consider environmental issues. However, coal liquefaction and gasification, improved gas-to-liquids technology and alternatives to oil, led initially by conventional and unconventional natural gas all offer additional potential. Hence the counter argument to the prevailing idea that we are locked in a death spiral of rising energy costs Natural gas is the world’s fastest-growing major energy resource. The US Department of Energy forecasts that global demand for it will double over the next two decades. Yet gas prices are very low relative to those for oil. The current ratio of 13.4 in the US (meaning 13.4 units of natural gas cost the same as one unit of oil) compares to a five-year average of 6.9. It reflects above-average stocks, and demand depressed by mild weather. In terms of energy content, gas has been trading at prices equivalent to $40 a barrel of oil, compared to futures prices for crude almost twice as high. The price for delivery over the next six years looks like a bargain, according to Union Bank of Switzerland. Wind farms and wave power appear short of economic sense as they are both very expensive. Nuclear power would be cheaper but the very word ‘nuclear’ still provokes resistance from some politicians, although others are warming to the prospect. It seems certain that the US will accelerate their nuclear power development proposals and the UK appears to be doing the same. Unfortunately nuclear power does not resolve the environmental problems resulting from vehicle emissions. Nor does it offer a quick fire solution, as the average development programme for new energy plants is ten years. And it does not resolve the problem that the majority of oil production goes towards keeping cars on the roads rather than power generation. The key question is whether we have reached what geologists term peak oil; output at the top of the production bell curve after which supply is always falling, together with higher costs of extraction. Regional analysts had to consider the realities of this during 2005 when the Burgan field, Kuwait’s biggest and the world’s second largest, passed its maximum production point. The one thing the gloomiest geologist and the sunniest economist can agree on is that world’s oil demand is rising. The International Energy Agency, which compiles countries’ figures and predicts demand, says that new consumers throughout Asia could push demand up to 121m barrels a day by 2030. The IEA suggests that oil producers must spend around $100bn a year on developing new supplies simply to keep pace. If world demand were to continue to grow at 2% a year, then almost 160 million barrels a day would need to be extracted in 2035, twice as many as today. Some are convinced the supply issue is not so vital. Assurances given last year at the MEED conference in Dubai for example, foresee increased oil supply as a result of extra expenditure in lifting capacity. But meeting the kind of demand above is almost inconceivable. According to industry consultants IHS Energy, 90% of all known reserves are now in production, suggesting that few major discoveries remain to be made. Shell says its reserves fell last year because it only found enough oil to replace 15-25 % of what the company produced. Production has not risen above the winter of 2004/2005 and world oil production will not rise above 86 million barrels a day. Saudi oil production has gone from 11 million barrels last year to 9.8 million this winter to 9.1 million in April. This is not to say oil is running out. On the contrary, there is global capacity for many years yet. However, about 944 billion barrels of oil has so far been extracted, some 764 billion remains extractable in known fields, or reserves, and a further 142 billion of reserves are classed as ‘yet-to-find’, meaning oil that is expected to be discovered. If this is so, then the overall oil peak arrives next year. This is not some scare mongering, headline grabbing tactic but indisputable fact. The point about peak oil theory is that it says that we are now reaching the point where no matter how much we want to pump oil out of the ground, we simply cannot pump it any faster. The challenge is not about resources but deliverability. Not only have the US oil majors not built any domestic refineries since the mid 1970s, the number of working US refineries has fallen from more than 300 in the early 1980s to less than 150. Obviously this means that the superpower is largely dependent on foreign supplies and vulnerable to even small accidents and bad weather. Nevertheless, US oil majors are raking in record profits, a situation that is causing a fierce backlash among consumers. In June, The New Yorker asserted it was “rational” for oil refiners to seek production limits so that prices, and profits can continue to rise without the huge additional investment that new refineries would require. Energy analysts argue that a major obstacle facing the construction of new refineries is the public’s distaste for the idea of massive and polluting plants close to their homes. So if we are at or about to enter peak oil, then global production can be expected to decline steadily at about 2-3% a year. Combined with the sort of heady demand we will continue to experience from the US to India and China, this can only lead to one thing, strong upward pressure on the spot price. This is certainly good for the region. As a net recipient this year of around $300bn from oil within the GCC, with at least $50bn heading into the UAE alone, the Gulf can probably expect the foundations to be laid for some new airports, business parks, roads and new themed projects. Some observers warn, however, that an economic boom often involves over expansion and diversification, which is due less to business prowess and ability and more to do with egos. Of course expansion and government largesse do not necessarily follow on from the financial windfalls that accrue to those fortunate enough to own such resources. Norway, already the world’s third largest oil exporter, earning an estimated $1bn a week, is positively frugal in its domestic expenditure, preferring to invest overseas through its pension fund, which will be worth more than $400bn by 2010 at current rates. It’s been noted that some Middle Eastern exporters fear that the potential loss of the petrol market will shrink their income . But given that oil is the primary ingredient of the plastics and pharmaceutical industries, it is never going to be anything but valuable even if we all switched to bicycles.||**||

Add a Comment

Your display name This field is mandatory

Your e-mail address This field is mandatory (Your e-mail address won't be published)

Security code