The oil crisis will come, but not yet

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The Independent Online
Will a surge in energy prices provide a justification for the renewed fears of inflation? It is an immediate issue for the financial markets, given their current preoccupation with inflation, but it is also a longer-term issue, because one thing that might alter the apparently well established downward trend of inflation would be rising energy prices.

The oil price is the obvious proxy for energy prices. Although oil on its own represents only 32 per cent of world energy use, the price has a direct impact on natural gas price contracts and together they account for more than half the total. In any case there are many applications for which there is no real substitute for oil.

So what is happening? The past six weeks have seen a sudden surge in prices, and the forward Brent crude price for August was above dollars 17 a barrel yesterday. This is a remarkable recovery from the trough in February this year when the price dipped below dollars 13, though still a far cry from the level two years ago, when it was around dollars 21.

So does one focus on the performance this year, in which case the upward move is quite worrying? Or should one take a longer view and argue that oil is still about the middle of its low-teens to low- twenties trading range, which it has been stuck in for about eight years?

There is a good argument to be made that, on an 18-month or two-year view, there is nothing much to worry about. Demand for energy still comes basically from the 'industrial' countries - the OECD members account for nearly half world demand, with the former Comecon countries pushing that total over 60 per cent. Demand will tend to rise with the economic recovery of the OECD, which will gather pace over the next two years.

But demand will not take off in any dramatic way because conservation measures, such as the rise in petrol tax in the UK, will bite into it. Since the US uses nearly twice as much oil per head as Europe and more than twice as much as Japan, as the balance of growth shifts away from the US, overall growth in demand will tend to slacken.

It seems a sensible working assumption that for the next two years the oil price will remain in the low-teens to low-twenties range. The breakout - which will be up, not down - will come later.

And that is the more substantial reason for concern. Demand will increasingly be driven not by the present industrial world but by the new one. The World Energy Council estimates that by 2020 developing countries will account for 60 per cent of energy demand. Demography alone will force up demand, and most developing countries are at the stage where additional wealth feeds very quickly into additional demand for energy.

On supply, according to WEC estimates, the proportion of energy demand satisfied by oil and gas will by 2020 have slipped below the 50 per cent level, with oil down to 27 per cent. Even so, oil production will have to be about half as high again as it is today.

That looks a tall order, particularly since there are only around 30 years of supply left at present consumption levels. True, the oil industry seems each year to find just about enough oil to replenish the amount it has pumped, and it may be conservative in estimating its proven reserves. But it will become harder and harder to keep pulling this trick. By 2020 the world oil supply will surely be tight indeed.

Long before then the oil market will match rising demand and tightening supply by pushing up the price. From the point of view of other financial markets, it matters greatly when this happens and to what extent rising energy prices translate into rising general inflation. The bond markets, after all, have to think 30 years ahead. If, for the final 10 years of a bond's life there is likely to be rising inflation, that has to be factored into the price now.

In other words, fears of a rising oil price from 2015 onwards are relevant to the price of new US Treasury securities. The markets are not thinking in these terms, or certainly not coherently, when they mark down the US long bond price. But maybe subconsciously a rising oil price now has had the effect of reminding them of the oil shocks of the 1970s.

If so, then we should be grateful. Even people who believe that the current concern about an upsurge of inflation is vastly overdone should worry about the poor energy discipline that low oil prices have encouraged. In itself the recent upward movement of oil prices need not become a serious worry. The long-term trend of global inflation is surely still down, and can weather a recovery in the oil price. The real inflationary threat from much higher oil prices is farther away.