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The Guardian: We have been here before: the price of oil will fall


Forecast in August 2005 from Vince Cable,  the former Chief Economist of Shell: “We have been here before: the price of oil will fall”

Monday August 8, 2005

Vincent Cable

One piece of conventional wisdom which is hardening into a truism is that oil prices will continue to rise. Recent headlines include: “Shell predicts two decades of rising oil prices” and “Oil will hit $100 by winter”.

The futures markets are expecting prices to continue to rise from just over $60 a barrel to $64-$65 in six months. The mainstream forecasters anticipate continued high prices in the short and even long term.

We have been here before. At the peak of the 1979/80 oil shock, when prices reached $80 a barrel in today’s terms, a poll of forecasters showed a consensus expecting prices to rise indefinitely. The forecasts were underpinned by the belief that supplies were becoming exhausted or that the Opec cartel had limitless capacity to adjust supply to maximise revenue. Little account was taken of the supply and demand response which led to the collapse of prices within five years. The old adage of all commodity markets that high prices lead to low prices was forgotten. It is being forgotten again.

The current spike in prices has its origins in a surge of demand led by the booming economies of the US and China hitting up against declining Opec spare capacity, which has fallen from almost 7m barrels to fewer than 2m barrels in under three years.

There is also a risk premium in the price reflecting worries about the stability of the Saudi royal family, the possibilities for terrorist attacks on key installations, the reliability of Russia as a producer of oil (and gas) and uncertainty over Iraq.

What theory and experience should teach us is that the current high prices will affect supply and demand. On the supply side, a lot of exploration and investment is already taking place in Opec countries and new areas such as the Caspian and the African continental shelf. Oil firms have developed new technologies for maximising yields and exploring inhospitable offshore reserves which are now profitable. Non-conventional oils like the “tarsands” of Canada and Venezuela are vast and believed to be profitable at around $30 a barrel, in effect setting a cap on the long term price.

On the demand side, the scope for easy economies in oil use has been limited by advances already made. The oil intensity of western economies (and China) halved after the oil shocks of the 1970s. But industry, already under pressure on energy costs, is having to economise and so will households.

A bigger factor is the impact of the oil spike on economic growth which affects oil demand. An oil price increase acts like an indirect tax on the world, reducing demand and increasing prices. A ready reckoner approach suggests that a sustained increase of $20 a barrel will reduce global GDP growth by 1%.

So far we have not seen any impact. In the last six quarters there has been 4.5% (annualised) global growth: an expansion without precedent. China and the US are still booming but this is most unlikely to be sustained. In the UK we are already seeing early signs of a slowdown.

One important factor is the ease with which Opec countries can recycle their windfall back into the world economy. So far they are spending energetically but a continued large windfall will pile up excess savings.

It seems clear that increased supplies, and capacity, and slowing demand will reverse the market trend before long, possibly very sharply. There are three conclusions for policy makers.

· The oil shock has enabled governments to escape from their responsibility to take tough tax decisions to limit demand growth in the interests of preventing global warming. The market is doing their job for them. But not for long.

· Even if short lived, this oil shock is causing real pain. The poor are being hit the hardest. The G8 annual $1bn debt relief package is being wiped out for oil importers in Africa with extra costs of $10bn a year. Emergency compensatory financing is urgently needed.

· Beware of energy companies promising to deliver “self sufficiency” and “energy security” in return for guarantees, subsidies and other protection. The big oil companies are not risking their shareholders’ money in projects which don’t break even at $20 a barrel oil; that should be a better clue to the future than the herd instinct of the markets.

· Vincent Cable is the Liberal Democrats’ Treasury spokesman,,1544461,00.html

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