Higher oil prices here to stay

Relative to world oil demand forecasts of late 2002 and the first quarter of 2003 the demand picture has consistently firmed up with growth rates of consumption rising, or staying very firm in all major markets.

Optimism by consumer country energy agencies on how much oil can be exported by Iraq has now given way to more realistic, lower estimates, as the 'Baghdad Bounce' upwards in oil prices continues. Apart from OPEC's Saudi Arabia, only Russia could raise export offer sufficiently and fast enough to create any serious potential of oil prices falling to less than $25-per-barrel.

In a sure sign of rising oil prices, consumer country media and opinion formers have returned to calling oil exporters 'greedy' and solely targeting maximized prices, while leaders of oil importer and consumer nations set economic, energy and geopolitical policies to obtain the lowest possible price. This is because of the pervasive, but laughably false myth that 'High oil prices hurt economic growth'.

The oil price collapse of 1985-86 and low relative prices through to 1999 have had no beneficial impact on economic trends for the OECD countries in particular. Average yearly economic growth rates for the leading G-7 countries fell by the massive amount of 50% through 1986-96 compared with their annual performance in the previous 10-year period. In that earlier period, of 1976-86, oil prices were much higher, often averaging $50/bbl in today's dollars.

Recent oil market trends, impacted on the sentiment side by declining expectations for breakthroughs in cheap oil supply from Iraq, by low inventories and rising demand, and by a fragile outlook for slowing the depletion rate of oil output by OECD producers, indicate that strong or even runaway upward bidding in oil prices could occur.

Faced by the resolve of OPEC to not break ranks, for the moment, little can in fact hamper or prevent oil prices being moved up to a new target price range. This range could reasonably be $36-$45/barrel. Firm and stable oil prices in this price range could well stabilize and strengthen oil industry investment and planning for an emerging supply environment that will become increasingly tight, barring an intense and global economic recession - which would require oil prices far beyond $75/barrel to trigger.

The levering up of growth rates for oil consumption, through improving economic performance can at least partly, and not ironically be explained by rising oil prices.

From their low around $10/bbl in late 1998/early 1999, to prices in a sometimes erratic band from $26-$36/bbl since 1999-2000, the impact of higher oil prices on world macroeconomic trends and notably on relative pricing terms between real resources, on one hand, and manufactured goods and services on the other, is on balance pro-growth.

This applies at the world economy level, and despite OECD regional recession trends in some economies (official recession in Italy, France and Germany). The relatively low real interest rates now available to many borrowers is a complementing economic growth factor. Another is increased world liquidity simply due to higher oil payments.

Recent OECD IEA and US EIA data suggest that world demand is around 77.9 to 78.4 Mbd on an all liquids base: data supplied by the IEA in its July 11, 2003 'Oil Market Report' indicates Summer 2003 world oil demand averaging 78.08 Mbd, and recent OPEC estimates place world demand at between 77.45 Mbd and 78.57 Mbd.

Relative to 2002 quarterly averages we are confronted by what BP Amoco in the Introduction to its Statistical Review of World Energy, 2003 edition, calls 'surprising growth'. On a worldwide base the underlying or trend rate of oil demand growth is at least 2.25% in volume terms. Through the period 1989-96, for example, the underlying rate was rarely above 1.3% annual.

South and East Asian demand growth, by country, despite the now retreating menace of the SARS epidemic (at one time slated to reduce regional oil demand by 0.5 Mbd in 2003), remains at 4%-6% by country, easily compensating slow growth in some European markets and Japan.

More surprising, however, is US oil demand growth. National demand at about 20.1 Mbd (1st Quarter 2003) has shown 2.9% growth through January-June 2003, and growth of about 0.6 Mbd comparing the first 3 months of 2003 with 1st Quarter 2002.

This growth can be partly attributed to stockbuilding but it is surely bolstered by fuel switching away from natural gas whose stepwise price rise to around $6.25/million BTU earlier this year makes $35/barrel oil competitive. Probably 0.25 Mbd of the 0.6 Mbd growth can be attributed to fuel switching away from gas to temporarily cheaper oil. Thus, despite the sluggish, erratic moving US economy, national oil demand is without any question very firm.

Probably through a mix of factors, including energy economy structure change US oil demand will likely show sustained growth, if not at a 2.9% annual rate then well above 2%. This also applies to several European economies - notably through progressive retreat of nuclear electricity capacity, replaced with natural gas and in some cases, on a temporary base, with fuel oil burning plant.

Chinese, Indian and Pakistani oil demand trends are well above 4% annual, with import demand growth sometimes in double-digit figures (for China 32% in 2002-2003). Demand growth trends for natural gas in these markets is yet more impressive - Indian gas demand is likely to increase 19% this year, with China's demand up by about 13.5%.

The slow economic growth outlook for certain regional players like South Korea, Singapore and Taiwan may now be at an end due to better economic outlook in the US and improving export market potentials in Europe on the back of a strong Euro. Both gas and oil demand growth rates for Taiwan and South Korea are in the 5%-7% annual range.

Declining virulence of the SARS epidemic, at one time slated to trim Asian oil demand by up to 0.5 Mbd this year, can further bolster demand in this region of fast rising capital investment in new industrial capacity and robust economic growth.

It is noted that the above-cited Introduction to BP Amoco's World Energy Review qualified the demand picture for both oil and energy as one of 'surprising growth'. This referred to the 2001-2002 outturn. During those 2 years equity markets took 50% and 60% losses and the world airline and tourism industry received a heavy blow from consumer reaction to the IX/XI or Sept 11th attacks on the USA.

It is therefore totally unrealistic of the OECD IEA to present forecasts for world oil demand in 2003-2004 increasing by exactly 1 Mbd, to 79.08 Mbd average by Summer 2004. This is a growth rate of 1.28%, not even the 'long-term trend rate' referred to by BP Amoco, of 1.3% annual

Both the IEA and EIA utilise a 1.6%-1.8% annual growth factor in their long-term forecasts. The real figure since 1999-2000, as a host of figures indicate, is likely above 2.25% annual for world oil demand, and about 2.75% for world energy demand. If we take 78.25 Mbd as the 2003 year average for oil demand, but apply a demand growth factor of 2.25%-2.45% we obtain a demand increase of up to 1.95 Mbd.

It is therefore very credible, under any scenario except a very rapid plunge into severe economic recession, that world oil demand will increase by over 1.7 Mbd in the next 12 months.

Significantly enough, in its July 11, 2003 'Oil Market Report' the IEA claims that supply 'from nonOPEC producers' will increase by 1.7 Mbd in the next 12 months, causing a loss of OPEC market share 'for a fifth consecutive year'.

In a sure sign of rising oil prices, increasingly strident calls are made, usually by Americans, for OPEC to be broken up. The 'Wall Street Journal' editorial writer Claudia Rosett, in an article on 29 July 2003 described OPEC's most recent meeting at which no production increase was decided as a 'gang of price-fixing oil-rich thug regimes meet(ing) to reinforce assorted terrorist-sponsoring tyrants at high cost to world consumers'. The article was given the title 'OPEC - One Purely Evil Cartel'.

It is possible, perhaps, to be surprised at such rabid and extreme language, but the reality of 'regime change' in Iraq every day indicates the real attitudes and motivation of so-called 'liberators'. Cheap Oil, as ever, is the be-all and end-all of this strategy and economic 'policy'.

All downside action in oil pricing since March-April 2003, when prices shaved the 'psychological ceiling' of $40/bbl can be traced to over optimistic interpretations of Iraqi production and export potentials in the short- and longer-term, on the supply side.

Recession trends notably in the US, German and Japanese economies were overvalued on the demand side, while the pro-growth impacts of higher oil and energy prices on world economic growth are underplayed or ignored. Oil prices were marked down to the $25-per-barrel range following Baghdad's capture but since then have rebounded.

Today, the extent of pillage, arson and vandalism of key infrastructures in Iraq, needed either directly or indirectly to produce and export oil is better known. Forecasts made by the US politician Dick Cheney that Iraq may export up to 2 Mbd by end-December 2003 are likely pure wishful thinking.

Little remarked, is the fact that military occupation forces in Iraq require about 0.4 Mbd of oil products, thus increasing domestic or interior oil demand in Iraq probably to more than 0.75 Mbd, with considerably more demand coming along when or if there is any serious economic reconstruction.

If Iraq's production can be 'ramped up' to 2 Mbd this winter, but the same or more occupation troops are needed to quell resistance, actual export offer may be no better than 1.25 Mbd. Prewar export numbers are highly variable and open to different interpretations, but it is likely they attained well over 2 Mbd (not including 'grey' and illegal exports, themselves around 0.4 Mbd).

Through June 2002-June 2003, according to the IEA, the OECD's 3-biggest oil producers, USA, Norway and UK, suffered a net loss of oil output, mainly through depletion, of 0.801 Mbd. Several OPEC producers now require very large investment spending simply to maintain export capacities, faced by often fast-rising domestic oil demand and fewer or no potentials for rapid increase of national production.

There are likely few major potentials for oil production increase outside the Middle East and Russia without significantly higher and firmer oil prices: the 5-year perspective for world demand growth at current rates, and accelerated depletion in key oil provinces, indicate a rapid and certain end to Cheap Oil.

It is very questionable if nonOPEC supply will automatically, surely and easily rise by 1.7 Mbd in the next 12 months, but it is increasingly certain world oil demand will increase by at least 1.7 Mbd - barring a severe and worldwide economic recession. The bottom line on oil exports from so-called New Iraq is therefore that world supply has lost at least 1.25 Mbd at a time when demand is increasing by about 1.7 Mbd per year.

At the same time many analysts in consumer countries repeat the unsubstantiated claim that OPEC's export offer capacity is as high as 31.9 Mbd when more realistic data suggests it will be difficult to achieve, then maintain more than 28.5 Mbd in the next 5 years, assuming very large investments.

Given the actual trend of investment cuts, notably in Venezuela and Nigeria due to economic and social difficulties, and uncertainty concerning oil prices, OPEC's real maximum supply capacity may remain set in the 26 - 27.5 Mbd range as a 5-year average.

The fact that very large investments are needed if OPEC suppliers are to maintain export capacity itself argues for significantly higher oil prices.

While there can be legitimate concern that over-rapid and overlarge oil price rises can trigger a defensive strategy of interest rate hikes, to strangle economic growth and oil demand in the OECD countries, this does not prevent prices from moving to higher, firmer and justified price bands.

The fragile supply environment is itself a permanent risk of runaway price rises when or if there is a supply interruption or cut of no more than about 4 Mbd, maintained for a few weeks.

In the present context it is highly unlikely that substitute supplies could be made up, and prices might be bid up through successive 'barriers' such as $50/bbl and $75/bbl, before defensive interest rate hikes were decided.

Oil price collapse due to recession would then freeze investment for maintaining world export capacity, leading to faster loss of world capacity. This would shorten the time interval before the next 'demand shock' resulting in runaway price rises.

Much better, both for world economic growth and for increased investment in the oil and energy industry, is stabilized oil prices in a range of around $36-$45/bbl over the next 12 months. This pricing level, it can be noted, was surpassed in constant dollar and purchasing power terms through 1975-78, in which OECD country oil demand growth rates averaged about 3.75%-4% annual with oil prices, in 2003 dollars at $38-$55/barrel.

Suggesting a price level somewhat lower than that of more than 25 years ago is difficult to call 'radical', more especially because economic growth rates for major oil importer and consumer countries at that time were around 2 - 3 times higher than today, while inflation was about 6%/year on average for the G-7 economies.

Moving up to this new price band can be the focus of serious and committed international attention to the risks facing both oil producers and consumers at this time. Runaway price rises in a free-for-all bidding process following supply loss of no more than 5% is the worst possible scenario.

Concertation and communication based on energy economic reality and emerging challenges to world oil supply from depletion are positive and pro-active responses to increasing needs for resetting oil prices.