Oil is in blow-off territory and a reaction in the price is inevitable, probably quite soon. But that does not mean that we will return to cheap oil in our lifetimes.
All right, take that with a pinch of salt. Hardly anyone a year ago successfully predicted the rise in the oil price to $120 per barrel – in fact I have not found a single forecast of that. The major oil companies early last year were still doing their planning on a price of around $40 per barrel, and I was talking a few weeks ago with the head of one of the oil giants who reckoned that if they had the full freedom to explore for it, the long-term underlying price would be below $50.
But in recent weeks several things happened that made a tight situation a really wild one. Most obviously, the fall of the dollar has gathered further impetus, particularly against the euro, now above $1.60. Part of the rise of the oil price is simply a dollar effect. Though the formal denominator is the dollar, the underlying price is de facto a basket of currencies of which the most important is the euro. As you can see from the first graph, there is a close relationship between the dollar/euro rate and the dollar-denominated oil price. Part of the case for believing that the oil price is unsustainably high turns on a belief that the dollar is unsustainably low. We'll come back to that in a moment.
There are other factors at work. Global demand remains strong, driven largely by the still-booming Brics – Brazil, Russia, India, China. There has been some reaction in the US, with demand for petrol falling, though not nearly as fast as it did during the 1970s and 1980s oil shocks. As the US economy slows further, expect that decline to steepen a little. Were the European economy to slow, as seems likely, that will curb another big oil user. In the past, when the main developed economies have slowed, there has been a swift impact on the price of oil, as the second graph shows.
This comes from Longview Economics, and shows the relationship since 1990 between the OECD economies' leading indicator and changes in the oil price. So when in 1999 the last boom was at its peak, the oil price more than doubled. When in 2001 the leading indicators signalled the forthcoming downturn, the oil price nearly halved. Now the OECD leading indicators are suggesting another downturn, though as yet not as serious as in the early 1990s or early 2000s, so you would expect the oil price to come down. It hasn't, of course, yet.
So you have to ask whether the growing weight in the world economy of the Brics, and in particular of China, changes everything. It is certainly changing the shape of this economic cycle, for, last year for the first time for a century or more, China added more demand to the world economy than the US. But if you look at absolute demand, the "old" developed world still uses a lot more oil than the "new" developing one. If the former really does cut demand, that will undoubtedly ease pressure on the price.
But in the long run, the issue is supply. In the past few days, we have had two significant bits of news. One is that Russian oil production fell in January and February, leading to suggestions that total output this year will be lower than last. The authorities have in effect acknowledged that this is likely to happen. Russia is the world's second largest oil producer. The other came this week from the largest oil producer, Saudi Arabia. The Saudi oil minister, Ali Naimi, warned of limited capacity among the Opec producers.
"Very little can be done by anyone," he said. "There is not enough spare capacity to help."
Since Saudi Arabia has long been the swing producer – the one Opec member that is able to adjust its production to meet swings in demand – this carries enormous weight. There are wider concerns about the scale of Saudi reserves and therefore its ability in the longer term to maintain production, but this is about the present situation, not the next few years.
It is true that non-Opec supplies are larger than Opec: the former account for a little over 50 million barrels a day, the latter some 30 million. But non-Opec producers are running flat out, so the incremental supply can only come from Opec. In the longer term, it is not at all clear that non-Opec producers can maintain their production, for new discoveries have to keep coming through to offset the declining production from existing ones, including incidentally the North Sea.
So why, against this background, might we expect some shading back in the oil price? Go back to the first graph. It comes from Capital Economics, who have stuck their neck out and predicted a fall to $85 by the end of this year. They think the dollar may fall further against the euro, maybe to $1.70, but by the end of the year they expect it to recover to $1.50. Were the relationship to hold, that could mean an oil price rising to $125 in the short term, but falling back to about $100 by year end. The case for that is partly that demand is slackening and partly that speculative positions in oil will unwind.
That seems sensible, and, if it does happen, very helpful to the world economy. Any easing back of the oil price takes pressure off other energy prices. Oil is a major feedstock for fertiliser, and so has been one of the things pushing up global food prices. (On that issue, by the way, it is a relief to see the short-sighted elevation of biofuels as a solution to the oil squeeze is at last being rethought.) If food prices fall back, that helps curb inflation globally. That in turn creates more leeway for central banks, including our own, to shade back interest rates.
So you can see, peering into the future, some relief. But none of this changes the big picture and that is that energy supplies will be tight for a generation. Oil is so convenient and the infrastructure is so based around it that it will be the principal source of energy for the foreseeable future. Somewhere around the corner another technology will replace it, but we don't know what that will be. Meanwhile we have to patch things together, try and use less of it, relying on lots of small adjustments to make the difference.
The advantage of oil at the present level is that it forces conservation. Previous oil price shocks had a temporary effect: the world did cut oil use but then forgot about conservation when the price came back down. You could say that what we need is a permanently high price of oil so that after this shock we do not return to our bad old ways. That looks like happening, even if in the next few months it is reasonable to expect some reaction.
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