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Financial Times: Lubricating oil

Published: November 10 2007 02:00 | Last updated: November 10 2007 02:00

The discovery of an oilfield thought to contain as much as 8bn barrels of oil and gas (the Tupi Sul field in Brazil) ought to prompt optimism about future energy supplies, but such is the growth in demand that, by 2030, 8bn barrels will be barely enough to supply China for a single year. The world is going to have to get used to high oil prices but, handled properly, the economic damage should be limited.

To say oil costs $98 a barrel is somewhat misleading. That is a nominal price in a falling currency for West Texas Intermediate, one of the world’s highest quality crudes, contracted for delivery in one of its biggest markets. But even looking at crudes from the Arabian Gulf, and adjusting for currencies and inflation, today’s prices are high.

In the short term they are likely to remain so. The lack of stockpiling makes it hard to believe the argument, often put forward, that there is a large premium in the oil price to reflect fear of a terrorist attack or another Middle East war. A level of supply that barely meets current demand makes more sense.

In the medium term prices should come down somewhat because, at or around $100 a barrel, a wide range of additional supply is viable, including oil sands, the conversion of coal to oil, marginal oilfields in areas such as the North Sea and massive investment in conventional oil exploration. If governments pass on the full price rise to consumers then growth in demand will also slow down. Power plants will switch to other fuels; drivers will buy smaller vehicles with diesel engines or switch to public transport.

But in the long term there is a physical limit to the amount of oil in the ground and no such limit on the potential demand from Chinese and Indian populations of growing prosperity. Big discoveries are getting rarer and estimates of endless Saudi Arabian capacity are dubious.

So far, higher oil prices have not caused the economic pain suffered in the 1970s, mainly because oil now makes up a smaller share of gross domestic product. Another 10 per cent rise from $100, however, will cause far more trouble than a 10 per cent rise from $30 a barrel.

Policymakers in oil importing countries need to tread carefully. The deterioration in their terms of trade will mean a fall in real profits and real wages which must be allowed to take place. Trying to stimulate demand, as in the 1970s, will only lead to inflation.

They should also resist any temptation to let a fall in the price of oil divert them from policies to restrain growth in demand and increase the supply of alternative energy. Quite aside from the need to reduce greenhouse gas emissions, China and India’s growth means that any such respite will be temporary. More expensive oil need not be a catastrophe or even a big problem for the world economy – unless we try to deny that high prices are here to stay.

Copyright The Financial Times Limited 2007

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