High prices threaten global economy

By Mark Goetz

Concerns expressed in early summer by Western countries that high crude prices could damage global economic recovery are beginning to look like more than just hand-wringing.

During August record high oil prices had a negative effect on world stock markets and fears grew in the Far East, where countries are highly dependent upon Middle Eastern oil imports, that economic recovery would slip.

Globally, economists spoke of higher oil prices giving rise to inflation that would be countered by central banks with increases in interest rates that would in turn put a damper on economic growth.

Despite OPEC’s assurances for most of 2004 that the market was well supplied, it appears that as the summer neared its end, demand genuinely was outstripping supply, especially in the Far East. And with OPEC producing full-out at more than 30 million b/d, it remains to be seen just what it will take to return the price of crude to the now long-forgotten days of the OPEC $22-28/b price band.

In the US, where the Presidential election is in full swing and voters are alarmed with the rising cost of gasoline, Democratic Party candidate John Kerry has unveiled an energy plan calling for measures that would end America’s dependence on Middle Eastern oil through the development of new technology and conservation. Although it is unrealistic for any major economy to imagine that it can free itself from dependence on Middle East oil, the idea is unsavoury for Gulf producers.

There was a time when OPEC’s rationale was to keep the market well supplied in order to deter any notion of developing alternatives to oil, but for several years now OPEC has attempted to keep prices up by maintaining a tight grip on supply ” a policy that prevented refineries from replenishing stocks. The current situation begs the question: would world crude prices be in this turmoil if there had been an adequate stockbuild during the last two years?

As it has turned out, rising demand, the war in Iraq and the overall fear factor of not knowing what might happen next, pushed prices to record highs by the end of summer ” and traders are now expecting greater demand ahead of the winter season, when prices usually peak!

Analysts are now expecting benchmark crudes to average in the neighbourhood of $40/b during the second quarter of 2004, and are forecasting that prices will come down during 2005, but aren’t sure why. Most of them have been taken by surprise by the degree of demand that has materialized in the Far East. During the first half of the year prices were attributed to the decline in value of the dollar, pipeline bombings in Iraq, the ups and downs of Russia’s Yukos affair, and nothing more than speculation. But by the end of summer, demand in the Far East, and particularly China, forced the analysts to focus their attention on fundamentals.

During times of great demand, the world has turned to OPEC to keep the markets supplied with crude. But this time there is alarm that OPEC (read Saudi Arabia) will not have the capacity to produce crude at a rate that will inject some stability into the market.

In early August when crude prices had breached $40/b and appeared to be ready to stay there, OPEC President Purnomo Yusgiantoro described prices as “crazy” and added that there was nothing OPEC could do as there was no additional supply, as OPEC members were already producing at 30 million b/d. A further round of price increases led Mr. Purnomo to announce that OPEC did happen to have some spare capacity of 1-1.5 million b/d.

Currently producing at around 10 million b/d, Saudi Arabia’s spare capacity comes from the new Qatif and Abu Safah project, which produces 800 000 b/d. But the discontinuation of some old wells will reduce this to 650 000 b/d and put total capacity at around 11.15 million b/d.

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According to Mr. Purnomo OPEC members plan to bring 1mn b/d of new capacity onstream by the end of the year and another 1 million b/d during 2005. But for the most part, it appears that OPEC will not be able to make the impact on the market that it usually can. According to some oil analysts, with no spare capacity to use to balance the market, only higher oil prices can halt the growth in demand.

Since the last collapse of oil prices, OPEC has sought to keep a tight rein on supply, but now it appears that the rein has been too tight. Should high oil prices bring about a recession, demand for oil will inevitably fall and prices will decline, production will slack off again and then the cycle will be complete yet once more.

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