Why this will be the best year ever for oil revenues

The politics of oil and the economy of the Middle East are deeply entwined, and this conundrum lies at the heart of understanding the outlook for oil prices in 2004.

This was supposed to be the year that Iraq started pumping three million barrels a day, and Opec failed to get its act together. But hold on a minute, Iraq is drifting into an open civil war, and Opec has just cut one million barrels per day from production.

Some oil experts believe oil could head towards $35 per barrel as soon as this week. That will dissuade the rebuilding of oil stocks around the world, and leave the supply position precariously balanced for the following winter.

Add to that the 23% surge in oil demand from China in January to 2.5 million barrels per day, and what looked like an easy call for the second quarter - a serious market oversupply - has been reversed in dramatic fashion.

Saudi Oil Minister Ali Al Naimi - who increasingly cuts a profile not unlike his 1970s' predecessor Sheikh Yamani - said last week that Opec had learnt its lesson from 1998 when a move to oversupply in a declining market sent prices tumbling below $10.

He noted that it took 18 months to get prices back up again, and that no self-respecting oil producing nation wants to see that happen in 2004.

The justification for Opec moving outside its former $22-28 per barrel price band is not hard to find. Step forward the massively overvalued euro which makes petro-dollars worth less in terms of the European imports on which the Middle East depends.

Caveat emptor, higher oil prices will cause inflation in the US eventually. This will cause interest rates to go up and the economy to slowdown, if not fall into recession. That then will dampen demand for oil both in the US and in the countries that supply its insatiable appetite for goods such as China.

Indeed, Chinese inflation is also at a six-year high of 3.5% and will soon begin to demand higher interest rates itself. Thus the time when China exported deflation already seems to be behind us, expect to pay more and more for Chinese imports.

However, in the short run higher oil prices look assured for 2004, and overall oil revenues could well comfortably exceed 2000 and 2003. There is an election, you may have heard, for the White House in November and gloomy talk of a recession can be forgotten until after then.

After that Opec will have a more difficult job to justify high oil prices in the face of an economic downturn induced not only by high oil prices, but also by higher US interest rates and higher US taxes. Thus 2004 may prove to be a peak in this oil revenue cycle, though that is what experts said about 2003.