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Energy Insights – Oil Prices

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Oil Prices

Is the oil price high?

The price of oil in real terms at $50 per barrel is still well under the $85 per barrel in 1980. In UK pound sterling terms, the price of oil would need to be over $110 per barrel to be equivalent to the 1980 peak oil price. Furthermore the global economy is far less sensitive to oil prices since industry is less energy intensive and the cost of importing energy is less of a proportional cost when compared to GDP than in the 1970s and 1980s.

Gas has replaced much of oil usage. However, because global investment markets are so sensitive to the threat of inflation, and each $10 per barrel increase in oil prices is thought to add about 0.2% to inflation – the financial markets are deeply concerned about increasing oil and energy prices. To sustain high growth and low unemployment – global markets need low energy costs.

It seems that anything below say $40 per barrel, industries can largely absorb the additional costs with without passing much of the cost to the customer. But over $50 per barrel – manufacturers and heavier industries feel squeezed and the financial services industries feel the pressure through lack of consumer confidence and investor nervousness. The oil price has risen dramatically – but whether it is high is subject to much debate. Oil prices have probably been too low for too long.

What oil price should I expect based on the economic and political forces acting?

Most of the OPEC oil producing countries have rapidly expanding and relatively young populations with increasing requirements for governments to provide social welfare – in part to maintain stability. These costs are rising annually which means the OPEC producing countries probably prefer to keep prices fairly high. This global economic process transfers wealth from the non producing developed (wealthy) countries to the OPEC producing and developing nations.

However, OPEC will likely not want oil prices to rise too high since this will stimulate the advancement and uptake of alternative energy sources – which could cause the oil price to crash and reserves to be devalued. This would also impact their financial situation with regard to banks and inward investment.

Meanwhile, the USA would like to see stability in the Middle East – so higher oil prices over $25 in 2002 initially did not cause any real concern. However, high oil prices act like a tax – and have the affect of stifling economic growth.

Initially there was a big concern that inflationary pressures would kick in when prices rose above $45 per barrel. This has so far not happened, though the higher oil price spooked the financial markets for a few months. Meanwhile, the decline in the US Dollar against the Euro and Yen has meant the positive impact for the OPEC countries is not as large as it would otherwise have been. This has also softened the impact of high oil prices in Europe – because of the high Euro value.

In view of the projected increase in oil and energy demand, one train of thought is that a higher oil price will stimulate the required investment to expand production capacity – otherwise there could be a big price spike in the future if demand outstripped supply capacity. So it seems that oil prices in the range of $35-50 per barrel are a range that both OPEC and the USA and other developed nations can accept.

However, the biggest impact of such higher prices is on developing countries with no oil production – e.g. most African countries, many countries in South and Central America – particularly those countries without coal or gas and high and increasing populations. This “tax” on their economies will stifle their GDP growth and lead to tough conditions for these populations and governments – one reason why foreign aid is so important and will probably become more so in future.

What are the key threats that could cause oil prices to rise further?

There are many of these. Examples in the last year have included terrorism, strikes by oil workers, hurricanes, cold snaps, heat waves, supply disruptions due to cold weather, political turmoil in oil producing countries, explosions at oil refineries and oil installations, comments on the lack of available spare production capacity, and tensions between different countries.

In 2005 and onwards, any indication that the production capacity increase is not keeping pace with demand increase will lead to prices firming. Any news indicating the Saudi Arabia or other OPEC countries are being too optimistic in their forecasts for oil production growth, reserves or forecast and actual field decline rates might also support prices.

Hoarding of oil by China and the USA into strategic reserves might also support prices. There seems to be a say $5-$8 tension/security premium built into prices at present – this could increase if tensions increase. Much will depend on what happens in the elections in Iraq and security within the country.

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