August 20, 2004

DEFLATION IS A TOUGHER BEAST THAN THAT TO KILL:

Coping with Sky-High Oil Prices: Why are they surging -- and how will the economy fare? It's likely inflation will stay cool, but so will hiring and consumer spending (Stanley Reed in London and James C. Cooper in New York, with Stephanie Anderson Forest in Dallas, 8/12/04, Business Week)

What's behind today's high oil prices?

It starts with an unexpected hike in demand. Rapidly rising oil consumption has eaten away the margin of safety provided by the ample spare production capacity recently provided by OPEC. With little surplus capacity available, buyers are worried that potential disruptions in a number of producing countries including Russia, Iraq, Saudi Arabia, and Venezuela could lead to major shortages and further spikes in prices. In 2001, OPEC had almost 6 million barrels per day in extra capacity it could call on. Now it is pumping close to flat-out.

Not only are prices high, but day-to-day swings of $1 or more a barrel are increasingly common as traders react to such news as the temporary Aug. 9 shutdown of production in Iraq. "The impact of any event is greatly magnified," says Paul Horsnell, head of energy research at Barclays Capital in London.

Why has huge demand caught the world by surprise?

A synchronized global recovery is the key factor. For perhaps the first time, most of the planet is growing in tandem. Demand, according to the International Energy Agency, is likely to grow by a record 2.5 million barrels per day in 2004, a 3.2% increase from last year. Consumption growth in 2004 alone is likely to be close to the total reached between 1998 and 2002, even though many had been predicting relatively stagnant demand.

The hottest growth area has been China, which clocked sizzling year-on-year increases of more than 20% in April and May. This year China will suck up 830,000 barrels a day more oil than last year, the IEA estimates, accounting for a third of world demand growth. As their incomes boom, the Chinese are buying cars even as the government rushes to build more roads to accommodate all the new traffic. Switching manufacturing from the West and Japan to less efficient facilities in China just adds to the nation's thirst for oil.

The U.S., too, continues to defy predictions as the economic recovery chugs along and as Americans continue to buy gas-guzzling vehicles and energy-gobbling McMansions. In the second quarter, America's demand for oil grew by 3.5%, the biggest gain since 1999.

Why hasn't production capacity kept pace with demand?

Both the oil majors and the national oil companies that dominate OPEC production have underinvested in bringing new supplies to market. OPEC's foot-dragging developing the 76% of world oil reserves under its sands and swamps is the biggest problem. Incredible as it may seem, OPEC's production capacity has actually declined over the last quarter-century from about 34 million barrels per day in 1979 to about 30 million barrels now. With OPEC imposing production cuts on its members to prop up prices, governments have seen little point investing in new output.

Political turmoil, wars, and nationalizations have led to production declines in major producers including Iraq, Iran, and Libya. And most Middle East producers have also severely limited oil companies' access to their reserves

In many respects, today's supply constraints stem from the late 1990s, when OPEC overproduction undermined the market. With prices approaching $10 per barrel back then, the oil majors became ultraconservative -- and they remain so today because they fear OPEC will once again pull the rug out from under them. As a result, they won't touch projects unless they promise at least 15% returns. What's more, pressure from profit-hungry investors has prompted the majors to chop exploration budgets and avoid taking big risks. [...]

Today's inventory levels, which are slightly below the five-year average, would, in a calmer international environment, be expected to produce prices in the low $30s per barrel. But as long as the international situation remains tense, prices will remain higher. Says Edward L. Morse, senior adviser at trading firm hetco in New York: "Fifty dollars looks much more likely than $30, and even $100 cannot be ruled out."

Still, many analysts think it will take a major event to push prices up much higher than they are now. What's encouraging is that the markets are coping quite well. There have been no major shortages, and buyers are able to secure plenty of oil -- albeit at a price. The situation could even ease somewhat in the coming months as Saudi Arabia, Iran, and Algeria add another 1 million barrels a day or more to capacity. That probably means that unless something happens to considerably worsen the supply situation, prices could peak at the mid-$40s (see BW, 8/12/04, "Are Speculators Driving Up Oil?").

"The only thing that's going to drive prices much higher is some big disruption," says Michael Smith, the head of energy analysis at BP PLC in London. Of course, it wasn't that long ago that analysts thought oil prices in the $30s couldn't last.

Do high oil prices have the same impact on the economy as in the past?

The answer seems to be yes -- and no. High oil prices still act like a tax that hits consumers and businesses on a material and psychological level. But the recent spike will not ignite inflation this time round. Indeed, with the job market weak, workers aren't able to negotiate wage increases that in the past have fueled rising prices.


So higher oil prices aren't tied to shortages of oil nor are they inflationary. It's a suboptimal situation, but hardly disastrous.

Posted by Orrin Judd at August 20, 2004 5:27 PM
Comments

The Hubbert Peak nears.

Posted by: Chris Durnell at August 20, 2004 7:16 PM

I see it peeping over the Big Rock Candy Mountain.

Posted by: oj at August 20, 2004 8:01 PM

The high oil prices are caused by uncertainty. Nobody knows what's going to happen in the Middle East (and the other oil producing areas) in the next year or two. As soon as this gets resolved, prices will go down.

Posted by: ray at August 20, 2004 8:32 PM

Agree with Ray. Traders who should know better are predicting oil at $60/barrel. Saw somewhere that supply and demand put oil in the low $30/barrel range and everything else is uncertainty/terrorism premium. The drop in oil today simply because the situation in Najef seems to be resolving itself is evidence of this.

Posted by: AWW at August 20, 2004 10:47 PM

Strange how there has been no analysis in the press about how the spike is affecting China, India, and other areas. All I have seen on this topic is how difficult things are for parts of South America, because they are already paying a premium for oil (except for Venezuela, there are no local sources).

A couple of questions: how much of China's supply comes from Russia? How much of China's bluster on Taiwan is related to the Spratly Islands (and the supposed mega-field)?

Posted by: jim hamlen at August 20, 2004 11:21 PM

A few reality checks are in order:

1. International uncertainty is the norm, not the exception.

2. World consumption of oil is rising and will continue to do so. The supply/demand ratio of today will be lower in 2 years, and lower still in 5.

3. Hubbert's Peak is real. In 1955 Hubbert predicted US oil production would peak in 1970. He was ridiculed, but the actual peak occured in 1971. World oil production will peak, it is just a matter of when. We won't know for sure until several years after the fact. For all we know, it has already peaked.

Posted by: Robert Duquette at August 21, 2004 2:51 PM
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