Fears of higher oil price look overblown

PUBLISHED : Tuesday, 08 January, 2008, 12:00am
UPDATED : Tuesday, 08 January, 2008, 12:00am

After the price of crude oil briefly touched a record US$100 a barrel last week, many observers seem to have accepted that the upward march of energy costs is unstoppable and that three figure prices for oil are certain as we enter 2008.

Yet continuously climbing oil prices are far from inevitable. There are good reasons to believe that instead of rising, crude prices could actually fall this year.

After nearly 10 years in which the cost of a barrel of crude has risen almost ten-fold (see chart), the arguments for an ever-higher oil price will be familiar to most readers.

Demand, especially from energy-hungry China, has soared in recent years, pushing up prices. Meanwhile oil is getting harder to find and more expensive to extract, increasing supply costs.

To make matters worse, a large proportion of the world's crude is sourced from geopolitical trouble spots such as Iraq and Nigeria, where supplies are subject to frequent interruptions, further bumping up prices.

At the same time, the world's refining industry is suffering from severe bottlenecks caused by years of under-investment in the 1980s and 1990s, which constrain the supply of petroleum products, adding to price pressures.

And finally, the value of the US currency is sliding, which pushes up the price of oil in US dollars even if it is static in terms of other currencies.

All of these factors played a role in last year's soaring crude prices. But they are not the whole story, and they do not necessarily mean oil prices will go on climbing in 2008.

For one thing, demand may not continue to rise as fast as assumed. One argument often cited for why high oil prices have not derailed global economic growth is that prices have been led higher by burgeoning demand rather than pushed by constricted supplies as in the 1970s.

However, with activity softening in developed economies following last year's credit squeeze, demand growth could soon begin to slacken. If a booming economy led prices higher, a softening economy could drag them lower again.

Do not expect demand from the mainland to fill the gap. Growth there has been a big influence on recent price rises, but according to analysts at Lehman Brothers, one quarter of demand growth between 1999 and 2005 was driven by the United States.

About half of that was the result of stronger demand for petroleum, but with petrol now costing upward of US$3 a gallon and new rules on energy efficiency and renewable fuel usage beginning to take effect, there are signs demand may have peaked.

That could trigger a rush for the exits by speculators. Since the credit crunch began to bite last year, hedge funds have switched from playing the debt markets to trading oil. Billions of US dollars have been pumped into oil futures since last August, driving a disproportionate gain in the price of crude compared with the retail price of petrol (see chart).

If underlying demand now softens, the speculative bubble could burst. Something similar hit the copper futures market last year, pushing prices down almost 25 per cent between early October and mid-December. If the same happens in the oil market, we could easily see crude drop back to US$75 a barrel long before it gets much further into three-figure territory.