The good news about oil is that Opec is not going to cut production; the bad news, that it will not increase it. So, oil stays above $100 a barrel? Or, thanks to the impending global downturn, falls back a bit? Or, thanks to the booming demand from Asia, continues on its upward path?
It is an issue of profound importance for at least half a dozen reasons. The most obvious is that three of the past four global downturns have been associated with a surge in the oil price – the exception being the post-2000 one, which was triggered by the ending of the dotcom boom. Another obvious one is that the prime driver behind rising global inflation is higher energy prices. A third is that for the first time since the early 1950s, increased energy costs are having a serious knock-on impact on global food prices. Fourth, since Asia seems, so far at least, to be continuing to grow despite energy strains, it is possible that this time round, slowing growth in the West will not pare back oil prices. Fifth, there are genuine concerns about long-term oil supplies and the consequences of a fossil fuel economy. And finally, energy is rewriting the global power game, shifting power away from Western Europe (excluding Norway), Japan and the United States and towards the Middle East, Russia and parts of Africa.
These issues are, of course, inter-connected but it may be helpful to try to separate them. So a word about each.
If the current downturn does become really serious, only part of the blame can be laid at the door of energy prices. We have poorly functioning credit markets, which are the result of excess lending by the banks, in turn the result of a period of very low interest rates and a surge in saving in Asia. So there has been a speculative bubble, akin to the late 1990s one, but characterised by money flooding into property rather than dotcom companies. That is the primary cause of the downturn. So if things get really nasty, while oil will be a contributing factor, it will be only partly to blame. However, high energy prices will inhibit the recovery, making it a longer pull out of the dip than otherwise would be the case.
One of the reasons for that is the impact on inflation, which appears more widespread in the sense that it is affecting China, India and the other emerging economies as well as the West. Inflation is nothing like as serious as it was in the 1970s, 1980s or even early 1990s but it is more serious than in the 2000 aftermath. There is a more troubling inflationary outlook than six or seven years ago partly because we can no longer rely on downward pressure from low-cost producers such as China, and to a lesser extent Eastern Europe, on the price of global manufactured goods. That helped mask mounting inflationary pressures, lulling our central banks (particularly the US Federal Reserve) into complacency.
The surge in food prices, however, is new. You can explain the strong commodity prices for items such as cement, iron ore and steel by looking at the Chinese construction boom. But in previous cycles, high oil prices have not had much impact on food prices: a bit but nothing untoward. This cycle is different. We are too close to the reality to be able to say exactly what is happening but there seems to be two main factors at work. One is the drive to convert food crops into energy products. Making ethanol or bio-diesel out of maize is perfectly possible but not particularly efficient because you are taking a crop that has been developed over a century or more for food and turning it into something that it was never intended to be used for. Subsidies make matters worse.
There is, however, another reason for the surge in food prices and that is rising demand for meat in China. Animals need fodder and producing that fodder reduces the food available for people. It is less inefficient to take, say, corn, and feed it to an animal, then eat the animal, rather than simply eating the corn itself. So part of the reason for higher food prices is rising wealth in China. Put the two together and food prices seem likely to remain high for some time.
The fact that Asia is continuing to grow rapidly does directly account for the pressure on the oil price. As you can see from that map of the world, the International Energy Agency in Paris is projecting that by far the largest increase this year will come from that region, with the result that the increase in demand this year will actually be greater than last year or the year before. North American demand this year is expected to fall, while demand from Europe last year fell. Put Europe and North America together and you can see that, over the 2006-08 period, there was no underlying increase in oil demand. All the increase has come from elsewhere.
There is a further difference from previous cycles in that the world is quite close to its production limits. Non-Opec supply is running absolutely full bore. If the oil companies could crank more out of the North Sea, Alaska and so on, they would at these prices certainly do so. But Opec also seems to be quite close to its limits. Saudi Arabia has traditionally been the swing producer. We don't know whether it can produce any more. It says it can but there are reports that it is having difficulty maintaining production. We do know that neighbouring Kuwait has called in foreign experts to tackle a problem of declining output. You don't need to buy the "peak oil" thesis (that the world is close to its ultimate peak output) to appreciate that Opec countries cannot produce a lot more oil, even if they wanted to do so.
Anyway, should they want to? Should Russia want to? To put the point bluntly, why should the oil producers increase their output when a large portion of the revenues are being accumulated in funds that then invest in Western financial assets that fall in value? Oil is a finite resource and financially it would make more sense to leave the stuff in the ground. Up to now, the oil producers and their sovereign wealth funds have been extremely responsible investors, for example shoring up US banks that are in trouble. But they are not universally welcome. Why pile up yet more money if, when you invest it, you find you are criticised? We are still in the very early stages of this shift in power and already several Western countries are uncomfortable about it.
Conclusion? Well, nothing goes up forever. There is some natural plateau for the oil price, for at some level it becomes economic to develop substitutes. Indeed, at the present level, alternative sources of energy such as wind power start to produce genuine profits. The present price also forces conservation, which is no bad thing at all. But oil is so convenient and underlying demand so strong that it is hard to see it falling back in price for long and the ultimate plateau may be a lot higher than $100 a barrel.Reuse content