As prices go through the roof, a structural change in demand may have already set a new floor
The immediate aftermath of Hurricane Katrina pushed oil prices above $70 a barrel this month. A barrel of West Texas Intermediate cost $10 as recently as 1998.
If analysts agree that current prices are a product of high demand coinciding with tight supply, there’s little consensus over how high prices could go and for how long. If supply constraints are (or, indeed, can be) loosened, the question of increased demand doesn’t look like it’s going away. When the market eventually rediscovers a realistic equilibrium – reflecting as closely as possible the underlying fundamentals in the medium to long term – it could be permanently lodged around the $50 mark.
The devastation of the Gulf of Mexico only served to exacerbate existing uncertainty over short-term supplies and capacity constraints the world over. While this is placing a premium (of perhaps as much as $15 a barrel) on current prices, emerging market demand, principally from China and India, has set a new price floor in recent years.
That’s certainly the view of leading analysts who envisage long-term prices at around that level. A recent Barclays report has stressed that current supply constraints are a legacy of a period of under-investment in the industry, leading to temporary shortages of refining capacity.
The oil market is continuing to test higher prices, which have thus far proved unable to slow consumer growth. Indeed, the world has been dealing remarkably well with recent prices. Adjustment without affecting growth has been made possible by the relatively gradual rise in prices, the role of developing world demand and the lower oil intensity of the wealthier economies. As demand has been sustained, so the price hike has continued.
OPEC, the cartel that controls three-quarters of oil reserves, revealed last week that its key members had drilled 7.5% more wells last year than in 2003.
When the supply issues are addressed, a drop back to the $50 range is most likely. But perhaps not even that far back: Goldman Sachs predicts $60 a barrel for the next five years.
Paul Horsnell, head of commodities research at Barclays, argues that the $20–40 prices of the 1980s and 1990s were never a realistic equilibrium: “It costs $1,500 per barrel for a brand-name cafe latte these days, so $50 for a barrel of oil is relatively cheap.” He maintains that current prices, minus the “uncertainty premium” simply reflect a reasonable return on producer countries’ investments. “Plus it’s a price that consumers can deal with pretty comfortably.”
That will exact heavy costs on the world economy, though, slicing 1–2% off annual GDP growth in South Korea, Turkey, China, Japan and the US. If predictions are correct, and global oil demand really does rise by 50% by 2020, then it will take more than refinery investment to curb prices further and sustain developing world growth in the long term. It will require the kind of capacity growth that the Cambridge Energy Research Associates (Cera) assessment is supposing – namely, a 20% net increase in capacity between by 2010.
But it’s worth noting that this conclusion represents the most optimistic end of the spectrum. The question of when global oil production will peak is a perennial one. Even if it’s true that the oil isn’t running out, it remains moot whether a medium-term rise in demand can be adequately met by increased capacity. If Cera’s figures do prove overly confident, and we are indeed witnessing the beginning of an irrevocable supply-demand imbalance, then the days of $70 (and higher) oil may only be beginning. —TL