Higher oil prices not a forgone conclusion

PUBLISHED : Monday, 19 May, 2008, 12:00am
UPDATED : Monday, 19 May, 2008, 12:00am

After the price of crude oil hit an all-time high of US$127.82 a barrel on Friday, it is worth taking another look at the dynamics of the market and wondering whether ever higher oil prices really are a forgone conclusion.

Certainly the prevailing view is that a barrel of oil is likely to get even more expensive in the short to medium term, and that it is sure to in the long run.

Last week, analysts at Goldman Sachs caused a stir when they predicted the price would average US$141 over the second half of the year, warning that it could climb as high as US$150 or even US$200 in a 'super spike' during the next couple of years.

Meanwhile, energy industry pundits are once again muttering darkly about 'peak oil', the idea that even as demand is rising, the world's oil production is inevitably sliding into irreversible decline.

But although the dominant view is that prices are heading higher, a minority of observers believe that more expensive oil is not such a sure thing.

One reason is that growth in developed world economies is slowing, with recession a possibility in the United States.

Most oil bulls point to rapid demand growth in the developing world, especially China and India, as the force pushing prices higher. But it is worth remembering that in 2006 the US consumed twice as much oil as China and India combined, while the developed countries of the Organisation for Economic Co-operation and Development (OECD) as a whole burnt twice as much.

With the OECD's composite leading indicators now heading south at a faster rate than at any time since the 2001 recession, some diminution of developed country demand looks inevitable. And as the charts below show, over the last ten years, when the developed economies have softened, so have oil prices.

But even if prices do ease later this year, many analysts believe the relief will only be temporary. Working on the premise that fossil fuel reserves are finite, they reasonably point out that a day must come when the world's production of oil reaches a peak, before entering an irreversible decline. As resources become ever more scarce, some pundits foresee economic collapse and war.

Although they are right to argue that oil production must peak one day, that day may not come as soon as they think and when it does, the impact is unlikely to be as severe as they expect.

For one thing, technological advances mean we have got much better at extracting more oil from existing fields. For another, although demand growth has indeed outstripped the growth in proven reserves over recent years, the imbalance is partly the result of a slowdown in exploration during the years of depressed prices in the 1990s.

With oil prices up, exploration is underway again and oil companies are looking afresh at exploiting resources formerly considered uneconomic, like Canada's vast tar sands.

Meanwhile, we still have around 40 years of proven reserves, with one entire continent - Antarctica - almost entirely unexplored. Drilling there would not be popular, but it would certainly be preferable to economic collapse and war.