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Ft: World Is Heading For Oil Price Shock

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I've been predicting energy prices rises for a couple of years now and that it would hit HP. Now it is starting to arrive I think I am just going sit here, stuff as much as I can into a crash fund and look very very smug! :rolleyes:

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The few bulls on here have been saying a shock is needed before an HPC occurs. Whetehr that is right or not is now a moot point. Oil is very likely to be that shock if it is required.

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World is heading for oil price shock

By George Magnus

Published: August 15 2005 20:05 | Last updated: August 15 2005 20:05

The price of crude oil is not only reaching new heights in nominal terms but approaching the record real levels seen in 1979. The significance of this latest “energy shock”, however, is perceived generally to be quite minor.

Consensus oil price forecasts one year forward, for example, remained at about $25 per barrel from 2000 until the end of 2004, when spot prices were already around $50 a barrel. The gap between consensus and spot prices has narrowed recently but the world still seems reluctant to buy into high oil prices for anything but the immediate future. It behoves us to ask if there might be more on the oil price menu than the normal fare of Chinese demand, temporary shortages of refining capacity and the occasional hurricane. There are three main areas that are generating new concern about the outlook for oil prices: context, supply and the effects on the world economy.

The unique context in which oil prices have reached more than $60 a barrel has important implications for geopolitics and climate change issues. Sustained high oil prices might actually help, in the long run, to reduce dependency on crude oil. But the economic issue that confronts us more immediately is energy demand, which has been growing since 2003 at about 2.5 times the rate of the prior decade. As is well known, much of this extra demand has come from China and India, which have accounted for about 35 per cent of the world’s incremental increase in oil consumption even though they account for just 15 per cent of world output. The oil consumption growth rates of these two emerging market behemoths and of many other countries in the developing world will continue to expand as growth in per capita incomes and the accompanying changes in consumption patterns towards more energy-intensive products evolve. It is estimated that global oil demand could rise by about 50 per cent by 2020. So, notwithstanding some recent evidence that suggests China’s oil demand is actually slowing down at the moment, the prospect over the medium term is for sustained and significant growth in demand.

The problem is that there are increasing concerns about supply. Oil is an 83m-84m barrel-a-day distribution business with realisable capacity in the short term of no more than a few hundred thousand barrels. Tight supply-demand conditions, though, are not, per se, unusual. The new concerns arise from some quite contrarian perspectives, summarised as “peak oil”.

Some think the peak in global oil production could be reached some time between now and 2008, others that it will come between 2010 and 2020, but most agree it is within the next decade or so. Concern about the depletion of conventional global reserves seems to have intensified for several reasons, including technological improvements in geological data gathering and analysis, the increasingly sparse reserves discovered by new drilling, and concerns that much of the world’s conventional oil, especially in the Middle East, is coming from old and over-exploited mega-fields that are becoming less productive. There is no risk that we are running out of oil but the chances of being able to match the estimated growth in demand over the medium term with a rise in production is being seriously questioned. Higher prices might not herald substantially higher (conventional) supplies.

To date, high oil prices have not really put stress on the global economy for at least three reasons. High prices reflect mostly the strength of global demand, specifically in the US and China. The developed world uses about half as much oil per unit of gross domestic product as it did in the 1970s. And recycling of oil wealth by producers is alive and well, with oil-exporting countries’ imports up by 32 per cent in 2004 and by a further 22 per cent in the first quarter of 2005. Countries with big external payments surpluses have invested in global, mainly US, capital markets and thereby helped to sustain low levels of long-term interest rates.

But there is no basis for complacency. The increased expenditure arising from the doubling in oil prices to $60 over the past two years amounts to about 2.7 per cent of GDP for the US. Amongst other net oil importers, the second heaviest burden has been on Africa at 2.3 per cent of GDP, or nearly $32bn. Consider that the Group of Eight’s Gleneagles debt relief programme for 18 African countries would save these nations some $1.5bn per year. For Europe, Japan, Asia and Latin America, the doubling in oil prices has cost between 1.7 per cent and 2 per cent of GDP.

The overall net impact of this change in oil prices has been offset by other factors. But what if oil prices were to remain high over the medium-term? The impact one year ahead, for example, of a permanent change (from $45 this time last year) to today’s levels above $60, with all things constant, would be to cause GDP to fall by 1-2 per cent in South Korea, Taiwan, Turkey and South Africa and by up to 1?per cent in China, most of Europe, Japan and the US. The effect on already stressed current account positions would be to push the US deficit up by a further 1 per cent of GDP, with lesser deterioration in Europe, Japan and China – which have the advantage of running surpluses, and sizeable ones in the case of Japan and China. The overall net transfers from oil consumers to oil producers by 2007 are estimated at about $1,500bn – or nearly 3.5 per cent of world GDP. This would amount to a recycling problem of increasing complexity, from both an economic and a political point of view.

It is against this background that the concept of “peak oil” becomes more worrisome. High oil prices might not simply be a cyclical phenomenon brought about by peak demand in this three-year-old global economic recovery. And nor would a cyclical decline in oil prices brought about by a US or Chinese slowdown in the next year negate the argument for structurally higher prices over the medium term. Instead, high prices might be an early indication of a supply-demand imbalance that can only be reconciled by still higher prices (recession or global slowdown notwithstanding). In that case, a more comprehensive oil shock surely awaits and that is with conventional oil production holding steady. Sooner or later, production levels will start to decline but that could be some time off. In the meantime, we may have to live with more expensive energy and keep a wary eye out for economic side-effects when the current spate of economic momentum weakens, as it must.

The writer is senior economic adviser at UBS Investment Bank

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