OIL at $50 a barrel "a foregone conclusion" and the market is now whispering $60, according to energy market analysts Platts, as the price hit new records last week. The latest price surge to $49 in New York on Friday is turning what was previously thought to be a ‘temporary blip’ into a step change for the world economy.
It is not just the knock-on effect of higher costs of raw materials that has to be factored in, but the effect of price uncertainty on business investment and confidence. Then there is the likely reaction of the highly-geared consumer. Little wonder growth forecasts across the board are being cut.
The price of oil is now 57% up over the past 12 months, counter to market expectations, in the wake of the Iraq war, that there would be a lasting fall. Even if it does not hit the most pessimistic projections, there is a growing conviction that the oil price is going to remain higher for longer, and that the era of cheap oil is definitely over. This means a big rethink of previous forecasts of a relatively gentle slowdown for the global economy and of a growth ‘pause’ in the US.
Threats to production in Iraq and Saudi Arabia have been the main focus of attention in recent days. And there is no doubt that there is a substantial ‘terror premium’ in the current oil price. John Butler, economist at HSBC, puts the supply side or risk premium element at between $10 and $15. We should certainly be doing something more than panicking - and certainly more than ignoring the problem altogether.
Last Friday, in a preposterous and Canute-like posturing, Joaquin Almunia, EU commissioner for economic and monetary affairs, noted the rise in oil prices but declared: "I don’t expect the strength of our economy to be hampered by that... I expect that we’ll hold on to our recovery and that we can even beat our latest growth estimate."
Whatever five star fluids Mr Almunia may be on, the reality is likely to be that the level of global growth will be lower by between 0.3% and 0.9% because of the oil price alone. The effects on the US economy are likely to be greater as evidence accumulates by the week that a slowdown is already underway. Last week, the Composite Index of Leading Indicators fell by a larger than expected 0.3% - the second fall in succession.
Now comes a call from Ed Yardeni, one of Wall Street’s most respected gurus, that the Bush administration should replace Saudi Arabia as the Federal Reserve of the oil market. It should, he says, cap the price at $40 by selling two million barrels per day from America’s strategic petroleum reserve (SPR) - currently standing at more than 660 million barrels.
The SPR is the world’s largest supply of emergency crude oil. It is Federally owned and stored in huge underground salt caverns along the coastline of the Gulf of Mexico. It came into being in the aftermath of the 1973-74 oil embargo. More than 500 salt domes are concentrated along the coast, and in 1977 the first oil was delivered. So far, the SPR has been used for emergency operations only once - during Operation Desert Storm in 1991. Together the facilities and crude oil represent an investment of more than 21bn in energy security.
Drawing on the SPR - which requires presidential approval - would at least rid the price of the ‘terror premium’. Yardeni suggests the proceeds of such sales, amounting to $29bn a year, should be put towards a massive acceleration of new oil and gas exploration and the development of technologies that would increase energy efficiency and reduce the West’s dependence on oil - especially Saudi oil. There can be no doubt that in any politico-military assessment of America’s strengths and weaknesses, it is the country’s chronic dependence on Saudi Arabia that is its Achilles heel.
But even if the ‘terror premium’ is reduced or eliminated, the world is still looking at a big hike in the oil price. The key driver of this has been the recovery in the world economy, with demand from China leading the way. Real oil prices have risen from around $22 a barrel at the start of 2002 to $40 at the end of May this year. During that period the world economy staged a strong recovery. Word trade in goods was up by 4% in 2002 and by 7.8% in 2003, with the first five months of this year seeing a similar annualised rate. But oil output has risen by just 5%.
Butler at HSBC says: "Given these developments, our estimates suggest that the mismatch between demand and supply can account for as much as 80% of the rise in real oil prices from 2002 to May this year. Put another way, of the move in prices from $22 to $40, the stronger than expected global recovery can account for a move up to $36."
But since then the price has moved up to more than $47. "We estimate that of the $25 rise in oil prices since the beginning of 2002, we would attribute $14 (or 60%) to stronger than expected global demand, and as much as $11 to other factors, possibly the greater risk premium," Butler adds. Of the higher demand, as much as 45% of the rise in consumption in the past three years is attributable to China and other parts of Asia.
Higher prices do not look to be slowing Chinese demand either. Chinese imports of crude oil jumped by 41% in July, with a year-on-year increase of 40%. Indeed, China’s demand for crude oil is likely to grow at a rapid pace as car sales boom.
The Chinese are building a superhighway system which is expected to be almost as large as the one in the US by 2020. The Chinese have more than four times the population of the US but about a quarter as much crude oil. "They are absolutely desperate for oil and other energy sources," says Yardeni, "and the producers know it."
This would suggest that the oil price, far from ‘spiking’, is set for further growth in the years ahead. The bad news in the short term is that the US slowdown is likely to deepen. Little wonder investors have become increasingly concerned that higher oil prices could depress the earnings of companies that must pay more for their energy.
"Higher oil prices," Yardeni warns, "are also a tax on consumers. If consumers are forced to cut back on their spending that would be bad news for the economy, profits and the stock market." And soaring oil prices, the normally ebullient Yardeni continues, "could turn last year’s bull market into a bear market this year".
It is to ward off this prospect that he argues for a programme of sales from the SPR. The draw down should only be used to cap the price at $40, he says, not to chase it lower. That still leaves the producers with huge gains, and America with a big incentive to lessen its dependence on OPEC. The cartel, which accounts for about a third of the world’s supply, is currently pumping at its highest rate since 1979.
I am not convinced that a draw down is necessary to kick-start a scramble for energy elsewhere. Better, I suspect, the prospect of a recession to get the necessary investment going in oilfields elsewhere in the world which were previously uneconomic - and also in refining capacity. Similarly, it is a real pinch of pain that will best trigger accelerated development of non-oil energy sources.
There is nothing like a higher price to bring oil streaming from the most unlikely places. This will help in the longer term. Short-term, however, it is going to be painful.
OPEC has always argued it has no interest in an artificially higher price that slows down the global economy and encourages investment in rival energy sources.
But matters are not as fully in its hands as was the case in the early 1970s and 1980s. That this is becoming clearer by the week should concentrate minds in the West to gear up for change.