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The Sunday Telegraph: Is the $100 barrel on its way?

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With oil prices rising amid tricky economic conditions, Sylvia Pfeifer wonders how much higher it can go

16/09/2007

Oil barons like to think they’ve seen everything, but last week the déjà vu was positively spooky. Ten years ago, ministers of Opec, the oil price cartel, congregated in the Indonesian capital of Jakarta to discuss whether to pump more crude. With prices trading at $20 a barrel and China beginning to demand more oil, Saudi Arabia persuaded other members to boost production by 10 per cent.

It would prove to be a fateful decision. The Asian financial crisis was unfolding and fears of a recession eventually cut economic growth and reduced demand for oil. Prices went into a tailspin and in 1999 they crashed to just $10 a barrel.
 
Memories of that November day in 1997 were rife when ministers met in Vienna last week. The parallels were eerily similar: oil prices are high and Opec is once again under pressure to boost production ahead of a winter supply crunch in northern Europe. This time, though, instead of factoring in a developing Asian crisis, ministers had to make their decision against the background of the continuing turmoil in the credit markets.

This time, Opec blinked. The group decided to boost production by a relatively small amount, an extra 500,000 barrels of oil a day, as of November. ” We don’t see sufficient evidence that there’s a need [for an output hike],” was how Chakib Khelil, the Algerian energy minister, explained the decision. “We still have a meeting [in November] and an extra meeting in December where we could make the right decision and not the wrong decision – like what happened in Jakarta,” he added.

No one knows whether Opec has read the runes right this time but the market reacted as if nothing had happened: oil broke through the $80 mark on Thursday night.

Speaking in Canada last week, Jeroen van der Veer, chief executive of Royal Dutch Shell, said he saw no fundamental reason why crude prices had breached such levels. “There is a lot of psychology in the price,” he said.

Van der Veer has a point, but he would no doubt admit that the era of cheap oil has been over for some time. While the real price of oil is still shy of its all-time peak, it is getting closer to the levels seen in the 1980s. And now that the barrier of $80 has been breached, there is a growing belief that the day of $100 oil is not that far away.

“It’s not difficult to put together a persuasive scenario where oil prices go slightly higher than $80 a barrel,” says Kevin Norrish of Barclays Capital. According to Norrish, the market fundamentals are enough to support an oil price of close to $80 a barrel; inventories are low and Opec production has not been that high. In addition, there is always a seasonal rise in prices ahead of the winter in northern Europe when companies stock up on crude. It would not take too much – a particularly severe hurricane in America or an outbreak of hostilities in the Middle East – to push prices above $80 a barrel. “The risks are there but the fundamentals are very strong. This is not a speculative bubble,” adds Norrish.

Jeff Currie, head of commodity research at Goldman Sachs, describes it as “a cyclical bull market for oil”. “There is a risk that the oil price will spike to $95 per barrel by the end of this year if the market remains in significant deficit,” he adds.

But what is keeping people like Norrish and Currie bullish on the oil price is the longer-term supply-demand balance. Production growth is slowing within non-Opec countries.
 
“There needs to be increased investment every year to stop the decline [in these regions],” says Lawrence Eagles, the head of market analysis at the International Energy Agency.

Battered by the low oil price 10 years ago, oil companies cut their spending on exploration and production. The result is that there isn’t the capacity nor the manpower to step up production that quickly. All this “pushes up the cost of finding new barrels”, says Eagles. As a result, companies are looking at alternative sources of oil – Shell is exploring the Canadian oil sands, while others like BP are drilling ever deeper in places like the Gulf of Mexico. But all this costs more money. “We need to have higher prices to generate the investment to increase output. We are seeing some new investment but it will take around 10 years to feed through,” says Eagles.

The lack of resources has also meant that some newer projects have not come onstream as quickly as they could have done.

“Some of the big projects were due to come onstream but the services sector has not had the capability to bring them online,” points out Andrew Bartlett, head of oil and gas at Standard Chartered. Kashagan, the giant field in Kazakhstan, has been delayed by two years.

Refining constraints are another factor that are likely to keep oil prices high. But perhaps the biggest driver is sheer demand for the black stuff. There has been a marked shift away from OECD countries to non-OECD countries.

Demand growth in China is particularly strong; although the country still uses far less energy per capita than any OECD country. In 1996, China consumed 3,702 barrels every day. A decade later, that had doubled to a massive 7,445 barrels every day.

India, too, is clamouring for more oil. The country imports between 75 per cent and 80 per cent of its demand, up from 50 per cent in the mid 1970s, says YK Modi, the chief executive of Great Eastern Energy, the Aim-listed Indian company. Modi is also among those who believe soaring demand from countries such as China and India will outweigh the current problems in the US.

Others, however, are more cautious. “Everyone is concerned at the impact the current volatility will have on the oil market,” says the IEA’s Eagles. “The downside risks to economic growth have increased.”

So how worried should we be about the impact of a high oil price on the world economy? Currie of Goldman Sachs points out the recent rise in prices has had less of an impact precisely because it has been slower than in the 1970s. “This has not been a spike, as in the 1970s, but rather a slow and insidious rise in prices, so the impact on the economy has been far less,” he says.

Another factor to remember is that Britain is now much less dependent on oil than it was 20 or 30 years ago – so the impact of high price on the economy will be lower. Net oil imports now account for only 1 per cent of GDP of the main group of developed countries, compared with 3 per cent in the 1970s.

Nevertheless, if prices do hit $100, the effect is likely to be rather more dramatic. An analysis of the impact of the $100 barrel by Ernst & Young’s Item Club predicts that GDP growth in 2009 would be 2 per cent – down from its current forecast of 2.4 per cent for that year if oil prices stay around $70 per barrel. CPI inflation would rise to 2.7 per cent in 2009, far higher than Item’s current forecast of 1.9 per cent.

So far, it is just a forecast but the million-dollar question remains: will prices hit the $100 mark? Barcap’s Norrish says he expects prices to stay around the $70-a-barrel level for the rest of the year but notes that “the risk is that it will be higher than that”. The bank’s forecast for 2015 is for prices to reach a very precise $93 a barrel. The simple answer is that nobody really knows.

The one thing worth remembering is that it is in Opec’s longer-term interest to ensure the world still relies on the black stuff to keep the wheels turning.

Dr Rilwanu Lukman, a former general secretary of Opec who was at that meeting in Indonesia, says: “In the longer term, it is only Opec member countries that have the capability to provide enough supply. “Opec does not set out to influence the market. It tries to balance the market so that neither the consumers nor the producers suffer. Nobody wants prices to go up unduly. We have learnt from the past that when prices go up, alternative sources of energy become more viable, so you have to be careful.” Oil barons like to think they’ve seen everything, but this week the déjà vu is positively spooky. Just over 10 years ago, ministers of Opec, the oil price cartel, congregated in the Indonesian capital of Jakarta to discuss whether to pump more crude. With prices trading at $20 a barrel and China beginning to demand more oil, Saudi Arabia persuaded other member countries to boost production by a hefty 10 per cent.

It would prove to be a fateful decision. The Asian financial crisis was only just beginning and fears of a recession eventually cut economic growth and reduced demand for oil. Prices went into a tailspin and in 1999 they crashed to just $10 a barrel. Opec’s power was under threat.

Memories of that November day were rife when ministers met in Vienna last week. The parallels were eerily similar: oil prices are high and Opec is once again under pressure to boost production ahead of a winter supply crunch in northern Europe. This time, though, instead of factoring in a developing Asian crisis, ministers last week had to make their decision against the background of the continuing turmoil in the credit markets.

This time, Opec blinked. The group decided to boost production by a relatively small amount, an extra 500,000 barrels of oil a day, as of November.

“Right now we don’t see sufficient evidence that there’s a need [for an output hike],” was how Chakib Khelil, the Algerian energy minister, explained the decision to the world’s press.

We still have a meeting [in November] and an extra meeting in December where we could make the right decision and not the wrong decision – like what happened in Jakarta before where we had the same situation and we made the wrong decision,” he added.

No one knows whether Opec has read the runes right this time but the market reacted as if nothing had happened: oil shot broke through the $80 mark on Thursday night in New York.

Speaking in Canada last week, Jeroen van der Veer, the chief executive of one of the world’s largest energy giants, Royal Dutch Shell, said he saw no fundamental reason why crude prices had breached such high levels. “There is a lot of psychology in the price,” he says.

Van der Veer has a point, but he would no doubt admit that the era of cheap oil has been over for some time. While the real price of oil is still shy of its all-time peak, it is getting closer to the levels seen in the 1980s. And now that the psychological barrier of $80 has been breached, there is a growing belief that the day of $100 oil is not that far away.

“It’s not difficult to put together a persuasive scenario where oil prices go slightly higher than $80 a barrel,” says Kevin Norrish, head of commodities research at Barcap.

According to Norrish, the market fundamentals are enough to support an oil price of close to $80 a barrel; inventories are low and Opec production has not been that high. In addition, there is always a seasonal rise in prices ahead of the winter in northern Europe when companies stock up on crude.

It would not take too much – a particularly severe hurricane in America or an outbreak of hostilities in the Middle East – to push prices above $80 a barrel. “The risks are there but the fundamentals are very strong. This is not a speculative bubble,” adds Norrish.

Jeff Currie, the head of commodity research at Goldman Sachs, describes it as “a cyclical bull market for oil”. “There is a risk that the oil price will spike to $95 per barrel by the end of this year if the market remains in significant deficit,” he adds.

But what is keeping people like Norrish and Currie bullish on the oil price is the longer-term supply-demand balance. Production growth is slowing within non-Opec countries, in particular in older oil provinces such as Britain’s North Sea, which is coming to the end of its life.

“There needs to be increased investment every year to stop the decline [in these regions],” says Lawrence Eagles, the head of market analysis at the International Energy Agency.

Battered by the low oil price 10 years ago, oil companies cut their spending on exploration and production. The result is that even though many are now flush with cash thanks to the high crude price, there isn’t the capacity nor the manpower to step up production that quickly. All this “pushes up the cost of finding new barrels,” says Segal.

As a result, companies are looking at alternative sources of oil – Shell is exploring the Canadian oil sands, while others like BP are drilling ever deeper in places like the Gulf of Mexico. But all this costs more money. “We need to have higher prices to generate the investment to increase output. We are seeing some new investment but it will take around 10 years to feed through,” says Eagles.

The lack of resources has also meant that some newer projects have not come onstream as quickly as they could have done.

“Some of the big projects were due to come onstream but the services sector has not had the capability to bring them online,” points out Andrew Bartlett, head of oil and gas at Standard Chartered. Kashagan, the giant field in Kazakhstan, has been delayed by two years amid soaring costs.

Refining constraints are another factor that are likely to keep oil prices high. But perhaps the biggest driver is sheer demand for the black stuff. There has been a marked shift away from OECD countries to non-OECD countries.

Demand growth in China is particularly strong; although the country still uses far less energy per capita than any OECD country. In 1996, China consumed 3,702 barrels every day. A decade later, that had doubled to a massive 7,445 barrels every day.

India, too, is clamouring fore more oil. The country imports between 75 per cent and 80 per cent of its demand, up from 50 per cent in the mid 1970s, says YK Modi, the chief executive of Great Eastern Energy, the Aim-listed Indian company. Modi is also among those who believe the soaring demand from countries such as China and India will outweigh the current problems in the US.

Others, however, are more cautious. “Everyone is concerned at the impact the current volatility will have on the oil market,” says the IEA’s Segal. “The downside risks to economic growth have increased.”

So how worried should we be worried about the impact of high price on the world economy? Currie of Goldman Sachs’ points out the recent rise in prices has had less of an impact precisely because it has been slower than in the 1970s. “This has not been a spike, as in the 1970s, but rather a slow and insidious rise in prices, so the impact on the economy has been far less,” he says.

“Price inflation is more important than that price level in determining the impact on the economy. When Hurricane Katrina hit [the US in August 2005], the price of gasoline jumped 70 per cent to $3 a gallon. This summer, gasoline hit a record $3.25, but it didn’t even make the headlines as the spike was just 12 per cent,” he adds.

Another factor to remember is that Britain, like the rest of the developed world, is now much less dependent on oil than it was 20 or 30 years ago – so the impact of high price on the economy will be lower. Net oil imports now account for only 1 per cent of GDP of the main group of developed countries, compared with 3 per cent in the 1970s.

Nevertheless, if prices do hit the $100 mark, the impact is likely to be rather more dramatic. An analysis of the impact of the $100 barrel by Ernst & Young’s Item Club predicts that GDP growth in 2009 would be 2 per cent – down from its current forecast of 2.4 per cent for that year if oil prices stay around $70 per barrel. CPI inflation, meanwhile, would rise to 2.7 per cent in 2009, far higher than Item’s current forecast of 1.9 per cent.

So far, it is just a forecast but the million dollar question remains: will prices hit the $100 mark? Barcap’s Norrish says he expects prices to stay around the $70-a-barrel level for the rest of the year but notes that “the risk is that it will be higher than that”. The bank’s forecast for 2015 is for prices to reach a very precise $93 a barrel. The simple answer is that nobody really knows.

Ultimately, it bears remembering that it is in Opec’s interest to ensure the world still relies on the black stuff to keep the wheels turning. Dr Rilwanu Lukman, a former general secretary of Opec, says: “In the longer term it is only Opec member countries that have the capability to provide enough supply.

“Opec does not set out to influence the market. It tries to balance the market so that neither the consumers nor the producers suffer. Nobody wants prices to go up unduly. We have learnt from the past that when prices go up, alternative sources of energy become more viable, so you have to be careful.”

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/09/16/ccoil116.xml

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