Oil: The power to shock

For the briefest of moments this week, the price of oil crossed the historic $100 per barrel threshold for the first time, pushed up by a single eager trader in New York. Fleeting though it may have been the price dropped almost immediately back down into the high 90s the crossing of that barrier was the clearest sign yet that the era of cheap oil was over and raised a raft of unsettling questions about the implications for the global economy.

The last time the black stuff had reached such heights in inflation-adjusted terms the price shocks of the 1970s widespread recessions ensued and governments enacted far-reaching efficiency programmes and poured billions into alternative energy technologies. The upshot was an overall decrease in global demand as the world learned to do more with less. Prices eventually relaxed, however, as the Middle East suppliers released excess supply into the market and several significant discoveries were made.

This time, it's different. Rather than being a supply problem as it was then, the inexorable march of today's oil price is being driven by the demand from emerging giants such as China and India, countries that show no sign of slowing. As Jim Rogers, the famed investor and commodities bull, described it: "You have three billion people in Asia who were not in the game 30 years ago when we had the last boom in commodities. But they have seen the television shows. These are no longer subsistence economies and they are wanting to live like you and I now."

It is anyone's guess how high the price will go, yet everyone seems to agree that a new, much higher floor has been set. Goldman Sachs recently increased its 12-month forecast to $105 per barrel. Ian Henderson, head of the JP Morgan Natural Resources Fund, says it could reach $110 in the first quarter of this year. Gerard Lyons, chief economist of Standard Chartered, thinks the US will fall into recession next year, which will translate to a fall to between $70 and $80 per barrel as demand falls. Yet that will only be a temporary blip before it resumes its rise over the next three to five years when, he says, it could hit as much as $150 per barrel.

Expensive oil, it seems, is here to stay. Why? In very simple terms, demand is outstripping supply. Today, Saudi Arabia is the only producer in the world that has the capacity to significantly increase supply. At the moment, it is producing about 9 million barrels a day, just over 10 per cent of the world's 85 million barrels a day of average production. The kingdom could pump up to an additional 2 million to 2.5 million barrels a day if it deemed it necessary. It does not. As the oil price made headlines this week, a procession of officials from Opec, the cartel responsible for about 40 per cent of the world's supply, trooped out to affirm that this was not their fault, blaming the situation instead on speculators. Supply, they argued, was sufficient.

But most of the world's major fields, found decades ago, are in decline. The "easy oil" has all been found, leading oil companies and producer nations to search for ever more difficult-to-tap fields that are vastly more expensive to exploit. The murkiness of just how much oil is left in the world is also partly to blame. Opec members set their production quotas based on the size of their reserves, so all have an interest in overstating how much they are sitting on. Mr Rogers singles out Saudi Arabia as the worst offender. "In 1988, the Saudis said they had 260 billion barrels of oil reserves. In the 19 years since then, they have pumped 69 billion barrels but still say they have 260 billion barrels. How can that be? These guys are lying," he said.

If expensive oil is the new reality, a bigger question then arises: how much longer can the economy remain healthy when the fuel that is its very bedrock used to power the lorries that put bread on supermarket shelves, to make the plastic bags to carry the food home, and the Tupperware containers to hold the leftovers is five times more expensive than it was five years ago?

For now, most analysts remain relatively sanguine. They argue that the global economy is in a much better position to deal with the rising costs because it is being driven by strong growth rather than a dramatic constriction of supply. Julian Lee, senior energy analyst at the Centre for Global Energy Studies, said: "In the shocks in the 70s, we had very dramatic rises in oil prices in very short periods of time, largely due to the supply disruption and the panic response of consumers. It's much more slow and steady now. We have had changes over three to four years when similar movements happened in a matter of weeks or months [in the 1970s]."

The market has already begun to respond. As the price has risen, global demand growth has decreased drastically in recent years, from 3 per cent in 2004 to 1.5 per cent in 2005 to an expected 0.8 per cent this year. Countries are also less dependent on petroleum than they once were after having invested heavily in alternatives energies such as nuclear and natural gas in the wake of the 1970s' crises.

Large corporations, meanwhile, have done their best to absorb the hit by reducing costs elsewhere principally employee salaries. Brandishing the threat of outsourcing and cheaper immigrant workers, companies have also managed to browbeat workers into being more productive and working more. Janet Henry, an economist at HSBC, said: "Corporates have dealt with it so far by keeping a lid on some of their other costs. Wage growth has remained very low in an era of phenomenal corporate sector profitability. There is a danger, though, that this will now be passed through."

Indeed, workers in Germany, for example, have begun lobbying hard for hefty wage increases after years of anaemic rises. Add to that a generalised slowdown in America and Europe and rising energy and food costs, and the picture is less rosy. John Hawksworth, the head of macroeconomics at PricewaterhouseCoopers, said: "Higher oil prices complicate the job of central banks by making it harder for them to respond to an economic slowdown with interest rate cuts at a time when headline inflation rates are rising... 2008 will be a challenging year for both policy-makers and businesses."

Yet it is not all dire. Mr Lee points out that there is nothing like a high oil price to goose governments and companies into seeking alternatives or introducing great efficiency measures.

Last month, President George Bush signed a new bill to raise fuel efficiency standards for American cars to 35 miles per gallon by 2020. It was the first time in more than three decades that the world's biggest oil consumer had passed such a law. The original bill was, not coincidentally, crafted in reaction to the Arab oil embargo in 1973. Mr Lee said: "There is an unprecedented degree of political and industrial support in developed countries both for alternative forms of energy like biofuels and greater energy efficiency. This might be the big change that these high oil prices are going to lead to."

The experts' view

Gerard Lyons Chief economist,Standard Chartered

"A permanent oil shock isone way of thinking about it.We think that the US will go into recession this year so the price could drop back down to around $70 or $80 per barrel. But any easing will betemporary. We currentlyhave a firm floor and softceiling on oil prices. We areanticipating a price of $150per barrel in three to five years."

Julian Lee Senior energy analyst, Centre for Global Energy Studies

"On the one hand Opec has under-estimated the level it needs to produce, while also adopting a policy of keeping the market relatively tight to push prices up... This is a very short-term windfall for them, though. They seem to believe that the world can live with $100 oil... But this willultimately drive the searchfor alternative forms of energy and greater efficiency."

Jim Rogers Famed investor andcommodities bull

"There has been no major oil discovery for the last forty years, and all the major reserves are in decline... When you have bull market like this, by the end prices get to hysterical levels that even bullish people like me cannot conceive. By 2018 or 2019, we could get to $200 or $300 per barrel. When it gets to $150 per barrel, they'll start drilling on the White House lawn."

Ian Henderson Manager of the JP MorganNatural Resources Fund

"The average price for 2008 will certainly be higher than it was for 2007, but the implications for most us will be zero. It's a question of pain threshold. Just look at Perrier. Most people pay more for bottled water than they do for petrol. So then it becomes a question of what you are more willing to give up: transporting yourself to or from London, or having a bottle of water."

Janet Henry Global economist, HSBC

"If the oil price stays at these levels it will become more of a constraint on growth, especially as it increases pressure on corporate margins and squeezes household incomes, as people no longer have access to easy credit... Corporates have dealt with itso far by keeping a lid on other costs, principally wage growth, which has remained very low in an era of phenomenal corporate profitability."