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$100-plus oil will be here for years as China motors ahead

telegraph.co.uk

$100-plus oil will be here for years as China motors ahead

By Liam Halligan

Last Updated: 2:08am BST 25/05/2008

 

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As regular readers will know, I’ve been warning about long-term upward pressures on oil prices for five years or more. But what happened on the markets last week left me deeply concerned.

  Oil markets dance the contango: Click to enlarge
Oil markets dance the contango: 
Click to enlarge 

Just when the world was getting used to the idea of $100-a-barrel oil, prices surged again – and on Thursday skimmed a staggering new high of $135.

Between 1999 and 2006, crude prices cranked up from $10 to $60 a barrel. Since then, they’ve more than doubled again.

And last week saw a new upswing – as the markets finally accepted that even if the US suffers a prolonged recession, global oil demand will continue its relentless rise.

It used to be a given that a slowdown in the US, the world’s biggest oil importer, would by itself bring about a fall in crude prices. And cheaper oil would then help the States get back on the path to strong growth.

But the world has changed. Any cut in oil usage by a slowing US will now be dwarfed by the unstoppable increase in the energy needs of the fast-growing emerging giants of the East.

To really understand what’s happening, one needs to peer into the crude futures market. This is a technical area, so I’d beg readers’ indulgence, for recent events in this arcane financial netherworld are hugely important.

While the price of oil for delivery now (the so-called “spot price”) is at a record high, prices on the futures market – for delivery in several years’ time – are even higher.

The 2016 future price has just raced above $140 a barrel, spiking $20 in less than a fortnight. The futures market is driven by smart people who think of little else but the supply and demand of crude in the months and years to come. And last week they imposed the biggest futures price rise in living memory.

The crude market is now in a rare state known as “contango” – with future prices above those prevailing today. So, the world’s top oil experts think that, in 2016, the gap between oil supply and demand will be even greater than now.

And that’s hardly surprising. China has 1.3bn people, four times more than America. At the moment, each American uses 10 times more oil than each Chinese – which is why, for now, the US remains the world’s biggest crude consumer.

But as China’s industrialisation continues, and its vast workforce becomes richer, demand for cars and household appliances will accelerate. Over the last decade, Chinese car ownership has grown at double-digit rates every single year. But there are still only 20 cars per 1,000 people in China, compared with 950 in the US. So the scope for higher car ownership is huge.

Around 70 per cent of global crude output is used to fuel cars. And if China’s per capita car ownership rises to only a tenth of American levels over the next decade, as seems likely, the impact on world oil demand will be shattering.

To China we must, of course, add Indonesia, India, Mexico, Brazil and the other populous emerging markets which are developing fast, and whose cars, factories and construction firms will demand more and more energy in the years to come.

With these realities now hitting home, the futures market has become extremely worried that oil supplies are not only failing to rise, but have actually started to fall.

There’s growing concern that 90 per cent of the world’s crude reserves are owned and controlled by governments – many of which aren’t friendly to the West. Traders are reminding themselves that a really major oil field hasn’t been discovered in more than 30 years.

Much is being read into the fact that President Bush was recently reduced to pleading with Saudi Arabia – the world’s oil lynch pin – to increase supply.

The trouble is, almost all Saudi oil is extracted from four or five giant fields more than 40 years old. Having given up their easily extracted crude, production can only be accelerated if these fields are flooded with water. But that drastically cuts their long-term yield.

So the fundamentals are clear. In my view, this soaring oil price is justified. But there’s something else – which relates particularly to the futures market.

Back in 2003, less than $13bn was invested in commodity index funds – investment vehicles that store wealth in oil and other tangible goods. By March this year, that amount had ballooned 20-fold – to $260bn – as institutional investors, pension funds and others have piled into commodities.

Demand for these funds is now growing by more than $1bn a day. And such investments are a big part of the reason why the oil futures price, in particular, have spiked so sharply.

But it is wrong to claim – as some do – that oil prices are high due to speculation, with the related claim that prices will soon fall.

That’s because the flow of funds streaming into commodities is, for the most part, long-term money. In the current world of high inflation, a weak dollar and weak central bankers, crude oil – and particularly oil futures – are increasingly being used as a store of wealth, a kind of proxy reserve currency.

That explains why the oil market is in contango. It also explains why $100-plus oil will be with us for years to come.

• Liam Halligan is Chief Economist at Prosperity Capital Management

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/05/25/ccliam125.xml

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