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High oil prices are based on fundamentals not speculative bubbles

By Liam Halligan

Last Updated: 11:10pm BST 14/06/2008

This weekend, UK motorists are queuing at petrol pumps as Shell tanker drivers take strike action. Violence has flared up on the Continent – with hauliers and fishermen railing against the fuel costs they say are crippling their trade. Across the world, in fact, high oil prices are now sparking protest – with demonstrations as far afield as Poland, Thailand and South Korea.

And now, the mighty Saudi Arabia has reacted. With a quarter of all known reserves, the desert kingdom remains the world’s biggest crude producer and global oil linchpin.

On Friday, Saudi announced an emergency summit, to be held next weekend in the port of Jeddah, inviting leading oil producers and consumers – including the UK and the United States.

In words that heartened Western politicians and central bankers, the Saudi oil minister, Ali al-Naimi, said current prices “are unjustified by fundamentals”. The Saudis apparently then went further – with anonymous sources saying a “sizeable” increase in oil production “may be proposed” at next weekend’s summit.

I don’t wish to be rude. Al-Naimi knows a lot more about oil than me. But “fundamentals” are very much driving the market. And even if we do see more Saudi oil in the coming months, it’s unlikely to lower the price of crude.

Oil prices have now risen seven-fold since 2001. Having surged 40 per cent since January, crude has already notched up 28 record highs this year. Even after falling slightly last week, oil still stands above $134. And a drop isn’t expected soon, with crude for delivery later this year close to $135.

Anyone wanting to understand what’s happening should peruse BP’s excellent Annual Statistical Review of World Energy, published last week. It shows the “fundamental” problem – oil demand running ahead of supply. And that gap is far more likely to widen than to close.

In 2007, the review shows, global oil demand was 85.2m barrels a day, up from 84.2m the year before. Global production, meanwhile, fell from 81.7m barrels daily, to 81.5m. So, global oil use is accelerating just as production is coming down.

Such price-boosting trends will almost certainly continue. On the consumption side – as is well-know – the relentless demands of China, India, Indonesia and the other “emerging giants” are unlikely to abate soon. As these countries continue getting richer, their rapid population growth and escalating fuel use per head will keep global oil demand spiralling upward.

OK – the Western world, in the grip of a once-in-a-generation slowdown, is starting to use a bit less crude. General Motors has just closed four US truck plants as more consumers go for smaller vehicles, which are often made overseas. Some airlines are cutting back on less popular routes.

But, as the BP numbers make clear, these tiny changes are completely dwarfed by the massive demand generated by the fast-growing emerging markets.

Oil use in the EU and the US combined fell 1 per cent in 2007, as prices hit $100 and the credit crunch took hold. Meanwhile, emerging market crude demand – in Asia, Africa and the former Soviet Union – rose 4 per cent.

Ah yes, you may think, but the EU and the US are much bigger. So, their 1 per cent fall has more impact than the 4 per cent rise in those tin-pot developing economies. Really?

While the EU and US combined used 35.6m barrels a day in 2007, the emerging markets, between them drained 36.2m barrels – more than the Western world. That’s never happened before. The fast-growing part of the planet is now using more oil than the slower-expanding “advanced” regions. And that trend, by definition, will continue.

That’s the horror of the demand side. How about supply? Well, as the graph shows, for the last 10 years, global oil production has been lower than world demand. But that’s been fine – because, as prices have steadily risen, making exploration more economical, more oil has been found. So “proven reserves” have kept rising – by around 15 per cent since 1997.

But, on the supply side too, the world has now changed. Not only is production falling, but as all the easy-to-reach oil is extracted, not enough new crude is being found to replace the reserves being used to plug the annual demand-supply gap. So proven reserves are now dropping too. The fall is only slight, but that’s still a highly significant event.

Al-Naimi’s claim that “fundamentals” aren’t to blame for high prices is a ploy, of course, to get the heat off Saudi and the world’s other big oil producers. The reality is Saudi crude output fell by 4.1 per cent last year – by far, the biggest absolute drop of any oil supplier.

Even if the kingdom does announce in Jeddah that it will soon start pumping from its new 500,000 barrel-a-day facility in Khursaniyah, the markets know that. The extra oil is already priced in.

In truth, Saudi has been issuing subtle warnings for years that the West’s addiction to oil, our constant demand for more, was putting their fields at risk. After all, the faster you pump, the more pressure is lost, and the more “dead” oil remains irretrievably in the ground. But we simply didn’t want to listen.

As this column has often argued, $100-a-barrel oil isn’t a spike, but a sustained reality. The Energy Information Administration, a branch of the US government, now admits as much. Crude is expected to average $126 during 2009, the EIA just told Congress.

So if anyone tells you these oil prices are “nothing but speculation”, they’re fundamentally wrong.

• Liam Halligan is Chief Economist at Prosperity Capital Management and its also non-profit sister websites,,,,, and are all owned by John Donovan. There is also a Wikipedia article.


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