We're scraping the bottom of the barrel: oil price puts global growth in jeopardy

Demand for the black stuff is gushing but supply isn't and the surge in the cost of crude to its highest level since 1990 shows no sign of running out of fuel. Opec is powerless, writes Tim Webb, and the world economy will suffer
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The Independent Online

Analysts from Lehman Brothers estimated at the end of last year that a barrel of Brent crude oil would cost $24 (£13) on average in 2004. Taking its cue from the terrorist attacks in Saudi Arabia, surging demand and low oil stocks, the price of Brent went above $36 last week. In New York, the price of the lighter West Texas Intermediate topped $40.

Analysts from Lehman Brothers estimated at the end of last year that a barrel of Brent crude oil would cost $24 (£13) on average in 2004. Taking its cue from the terrorist attacks in Saudi Arabia, surging demand and low oil stocks, the price of Brent went above $36 last week. In New York, the price of the lighter West Texas Intermediate topped $40.

Prices are now at their highest since 1990, when Saddam Hussein invaded Kuwait, and higher than they were in the run-up to the second Gulf war last year. Compared to this time in 2003, Brent is more than $10 per barrel, or 40 per cent, higher - to the astonishment of economists and analysts who have been predicting a crash in oil prices. Paul Horsnell, the head of research at Barclays Capital, says: "That cry has been the oil analysts' equivalent of walking around with a sandwich board proclaiming a very rapid end for the world."

Clearly, they were wrong. The Bank of England said last week that it had decided to increase interest rates partly in response to rising commodity prices. Oil prices may drop a couple of dollars between now and the end of the year, but no one is predicting they will drop below $30 any time soon.

So how high can they go? And is the global economy - and that includes us - heading for the first oil crisis of the 21st century?

Global demand for oil is rising as the economy picks up, driven in large part by China. Barclays Capital estimates that total worldwide consumption for 2004 will be 80 million barrels of oil per day, up from 78.6 million in 2003. The growth in demand from China alone makes up almost a third of the increase.

Seasonal demand is about to spike too with the approach of the "driving season", mainly in May and June when petrol consumption increases as Americans drive across the country in their gas-guzzling four-wheel drives to go on holiday. Petrol stocks in the US are already low. But new environmental regulations introduced by the government requiring refiners to strip out the chemical MTBE, believed to cause cancer, have helped to exacerbate the shortage this year, as there just aren't enough refiners around which comply with the regulations.

Petrol stocks are estimated to be 13 per cent lower than needed to meet the demand during the driving season. As a result, the US will import more petrol from Europe, putting further pressure on crude supplies.

Dr Manouchehr Takin from the Centre for Global Energy Studies, a think-tank set up by the former Saudi oil minister, Sheikh Yamani, says that speculators have also played their part in pushing up the cost of oil. "People are prepared to pay higher prices for gasoline because there is a fear of shortage. But in the last six months, even pension funds have been speculating, joining hedge funds. The expectation was that they would go short on supply, but many are still holding long positions." This suggests the market expects prices to go higher.

But there is little hope of a sudden glut of oil coming on to the market to meet rising demand. The Organisation of the Petroleum Exporting Countries (Opec), which pumps some 40 per cent of the world's oil, no longer seems willing - or able - to manipulate prices by changing production levels. Its quotas are rarely met and are becoming irrelevant.

This was underlined by comments last week from Indonesia, the holder of the Opec presidency. An official explained the high prices were caused by speculators and not a shortage of oil, as the cartel is already producing more than two million barrels above its official quota. Ironically, its last quota was meant to cut one million barrels last month because demand was expected to fall after winter in the western hemisphere; the Centre for Global Energy Studies estimates only 400,000 barrels were cut.

The admission that Opec is once again not meeting its own quotas is not news to anyone. Officially, the cartel is still committed to keeping oil within a price band of $22 to $28 a barrel. If prices are above this for more than 30 days, it is supposed to gear up production automatically. This mechanism is now meaningless: Opec's own price has been above $28 since December and there have been no moves to increase production, other than the unofficial quota cheating. In March, Purnomo Yusgiantoro, the Indonesian oil minister and Opec president, suggested a new range could be set at around $32 to $34 a barrel.

Opec is in a dilemma. Privately, the cartel members are happy to see such high oil prices, even though they would not admit it publicly for fear of angering consumers. Most of the members have huge budget deficits to service and are largely dependent on oil revenues, both politically and economically. In Saudi Arabia, for example, some estimates put unemployment as high as 30 per cent. If prices fall, hitting government revenues, criticism of the ruling Al-Saud family will increase.

But Fatih Birol, chief economist at the International Energy Agency (IEA), says Opec's laissez-faire policy is "myopic". In the long run, it will lose market share, he says, because higher prices will lead to lower consumption as oil is used more efficiently and as more non-Opec producers are encouraged to pump more oil. "It's better to have medium prices and higher production than high prices and see their market share decline to non-Opec producers."

In the short term, however, the scope for outside producers to meet the shortfall is limited. The US and Europe are all pumping less oil than two years ago, according to Barclays Capital, and the performance of non-Opec countries this year is even weaker than expected. In other words, with demand expected to remain strong, and no gush of new oil predicted in the foreseeable future, the current high prices are unlikely to be a short-term phenomenon.

The IEA released a report last week analysing the effect of this on the global economy. It makes for sober reading. If the oil price sustains the $10 per barrel increase from $25 to $35 for a year, in the developed world, inflation will increase on average by 0.5 per cent, GDP will fall by 0.4 per cent and unemployment will increase, the report predicts. The impact will be bigger the more oil a country imports. The IEA adds that the current high prices are hurting the global economic recovery, noting that sustained oil price inflation from 1999 contributed to the downturn in 2001.

The UK is still a net exporter of oil and gas, but will become a net importer by the end of the decade as the North Sea fields age. Oil consultancy Wood McKenzie estimates the industry paid £9.5bn in total in tax to the Treasury last year. Because production is falling (in 2005 the UK will become a net importer of gas), the tax take is unlikely to be equalled, even with high oil prices.

Businesses will also be affected. John Butler, an economist at HSBC, says companies are more sensitive to higher oil prices because margins are already low: "In the past, they have tended to be a cost that companies have been able to pass on. Now, perhaps because of greater competition, this is not always possible. The impact may not be in terms of rising RPI [retail price inflation] but more in dampening profits, hurting employment and a negative impact on GDP growth."

The developing world will be still worse off, the IEA warns, as the poorest economies use more oil and less efficiently. It estimates that a sustained $10 a barrel increase would cut the GDP of countries in sub-Saharan Africa by more than 3 per cent. And their currencies would also become devalued as the dollar-denominated bill for imports increased, also raising the cost of servicing Third World debt. Mr Birol at the IEA says: "Developing countries like India can't afford these rises. They suffer more than OECD [developed] countries."

Prices are not as high as during the 1970s oil crisis, when crude hit over $70 a barrel in today's money after Opec turned off the taps. But in many ways, the current outlook for oil is more serious. Today's high prices are not the result of manipulation by a cartel. They are instead the product of a longer-term trend: the world is consuming oil at a faster rate than it can find it. In the 1970s, Opec backed down and prices returned to more acceptable levels. If only the solution were that simple now.


The recent surge in oil prices has raised the spectre of a repeat of the fuel strikes in September 2000, which almost ground the country to a halt.

Ray Holloway, the director of the Petroleum Retailers' Association, who helped co-ordinate the protests, has warned Gordon Brown, against raising petrol duty. The Chancellor announced a 1.9p per litre extra duty in his latest Budget, but deferred its introduction until 1 September.

"We are already paying a high price at the pump," says Mr Holloway. "Gordon Brown will come under pressure not to introduce the duty. His option is to consider whether British businesses can cope with the type of strikes we had before."

Farmers and road hauliers are particularly opposed to the planned hike, he adds.

The average price for a litre of unleaded petrol in the UK last month was 78.6p, according to the Automobile Association. Prices have since increased to 80p per litre in some areas. The highest monthly average in the last three and half years was in June 2000, when prices hit 85p.

But Mr Holloway says there is room for negotiation: "Our first thought is not to protest."

A spokesman for the Treasury says it is in regular contact with road user groups about issues such as fuel duty but adds that it has no plans at the moment to defer the September increase. "We always keep the position under review. No decision would be taken about it until nearer the time."

Among the other losers in the great oil game are the airlines. Analysts at Dresdner Kleinwort Wasserstein have downgraded their earnings forecasts for British Airways. In March, the airline said it had only hedged 30 per cent of its fuel needs for the first half of the year, and 12 per cent in the second half, which could lead to a hit of £50m or more in the financial year ending March 2005, according to the DKW analysts. Other airlines hedge more of their fuel needs.

Times are tough, as shown by last week's easyJet warning that the cheap fares it is charging are unsustainable. With many American airlines only just recovering from the after-effects of 11 September, and Italy's Alitalia flirting with bankruptcy last week, a fuel shock is the last thing the sector needs.

The undisputed winner from the surging oil price is, not surprisingly, the oil and gas sector. Shell and BP have both announced share buyback programmes over the year to return surplus cash to shareholders generated by high oil prices.

British oil and gas exploration and production has raced ahead in the past six months. Cairn Energy is typical of the smaller oil companies: its share price has more than doubled since January after major finds were made in India. The fact that it bought the Rajasthan field from Shell, which is now desperate to boost its production after its reserves scandal, makes it all the sweeter.