Why oil prices will stay high for five years

At the start of 2003 one of the most widespread predictions from economists was that the oil price would fall as the year went on.

True, after reaching war-time peaks of around $40 per barrel, prices have eased back under $30 per barrel. But we are now in Q3 of 2003, and this oil price is way above expectations.

The short-term reason is clear. The rehabilitation of Iraqi production is taking longer than predicted post-war due to looting, sabotage and general anarchy.

We are now told that a return to full pre-war production levels is likely by the end of the year, presumably by the same people who thought we would be back to full production by now just a few months ago.

Oil is a matter of supply and demand, and when supply increases the price will fall, say the experts. Yes, but what if demand is much higher than expected and the supply side continues to disappoint?

Step forward the world's fastest growing economy. China is growing faster than anyone forecast this year, and has to import oil to sustain this growth.

In the past decade Chinese oil consumption has doubled to around 4.5 million barrels a day, and has to import most of its oil from the Middle East because its own resources are small. Now if China sustains its 10% plus rate of economic growth, it is not hard to see that China represents a major new source of oil demand.

But let's not forget the Western economies. Surely the sort of fiscal and monetary stimulus applied by the US over the past year will soon produce a resumption of strong economic growth. Maybe it will be next year, rather than this year, but it certainly will happen.

Then we will see oil consumption rising again. However, as we saw in the mid to late 1970s there is no reason why a bull market in commodities can not be sustained during a period of lacklustre economic growth.

Indeed, the parallels between what happened in the mid-1970s to the global economy and the situation today are very strong. A war in the Middle East followed by an oil price surge, stock market crash and sub-par economic growth.

There is also the theory that under such conditions excess liquidity will find its way into commodity prices as it has nowhere else to go. Again high oil prices are sustained long into the future and for much longer than most economists currently believe is possible.

For the Middle East this is clearly extremely good news. A third great oil boom is happening right now and will last long enough to make many people extremely rich.

I would argue that this position will only be reversed when there is an overinvestment in new production capacity. And after a 20-year bear market in commodities, it will be some time before investment in new capacity really gets into top gear. Hence, high oil prices will last for five years.