Bill Jamieson: Is QE pumping up the price of oil?

‘Brent prices bottomed out soon after QE was launched in the US and the price has been on an uptrend since’

LAST week the price of a barrel of Brent crude oil climbed to $123.89. This is up almost 25 per cent since October and its highest since last May. Vitol, the world’s largest energy trading house, warns that oil could be heading for a record high of more than $150 a barrel.

It will be music to the ears of Scotland’s First Minister Alex Salmond. The higher the oil price, the greater the revenues that would in due course accrue to the coffers of an independent Scotland.

But just when the Bank of England sought to assure us inflation was definitely on the way down (really, really this time) and that the road was clear for another splurge of Quantitative Easing, along comes the stuff of central bank nightmares: an oil price spike.

The North Sea is estimated to hold some 20 billion barrels of oil and gas. And new discoveries combined with improved extraction technology means the rate of decline may not be as steep as many have feared.

But it’s the immediate impact of a rising oil price that is not at all favourable.

How could the oil price spike upwards in today’s conditions? Europe is in recession. The UK is only just managing to skirt round one. And the economic recovery in America, while heartening, is still far from being assured and sustainable. So how could this be?

Explanations range from fears over Iran’s nuclear intentions, ever tightening sanctions against the regime, heightened tensions in the Middle East, oil inventories at multi-year lows and strengthening demand from emerging market economies.

Not only does a rise in the oil price threaten higher inflation through a direct hit on households – rises in the price of petrol and heating oil – but it also works in a thousand different ways to add to inflation pressure across a broad front, lifting the price of oil-based products and manufacturing costs for thousands of firms. And there is another consequence: a slowing of economic growth.

There is no doubt Iran is a factor as sanctions bite harder. Data compiled by Oil Market Intelligence shows Iran’s oil output dropped from 3.6 million barrels per day during November to 3.3 mbd during January, the lowest since February 2002. Iran’s exports of two mbd could be cut in half to one mbd or lower as a result of sanctions. This hardly signifies when set against a figure for global crude oil supply of 88 mbd in January. But the price is also being driven up by fears that a confrontation with Iran could set off a conflagration in the Middle East – by no means certain, but a risk nonetheless.

But there’s another factor that may be playing on the price – the combined effect of monetary easing by the US Federal Reserve, the European Central Bank, and the Bank of England, where another £50 billion burst of “QE” sanctioned this month has helped to fuel demand for commodities in developing country economies and contributed to a weakening of the sterling exchange rate.

In US dollar terms the oil price is still below the $147 level it reached ahead of the banking crash in 2008. But the price measured in weakened sterling and euros is now close to record levels

What a long way we have come since the Brent oil price averaged around $20 a barrel over the period 1985-2004. Since 2005 the price has nearly quadrupled. And this coincides with weakening growth in Western economies. The most recent oil price increases have intensified debate about the role of QE in driving up oil prices. Last year the price of Brent crude averaged over $100 for the time ever – accompanied by firm denials from the US Federal Reserve and others that quantitative easing policies were fuelling commodity price increases.

Now this may not be the dominant influence on the oil price at present. But as an HSBC global economics research paper titled Oil And Money concludes: “QE is playing a role in pushing oil prices higher as well as by turbo-charging emerging market world growth.”

And the paper argues that a slowdown in the big G7 economies no longer works to bring down the oil price as once it did. “The historical link between a slump in developed economy growth and lower oil prices globally,” writes analyst Madhur Jha, “has been broken, since emerging markets now account for nearly half of oil consumption.”

Developed world monetary easing, she argues, has been ineffective in boosting growth to the extent that it has stoked oil price increases, resulting in an unfavourable growth-inflation trade-off. And ironically the main response to an oil-price induced slowdown in growth is... well, more QE.

Brent prices bottomed out soon after QE was launched in the US and the price has been on an uptrend since. This would suggest, writes Jha, “that QE has played some role in boosting oil prices”. But how exactly has it done this?

On HSBC analysis, QE has played only a limited role in raising speculative activity relating to oil. But it has certainly played a part by supporting global growth expectations. QE does not stay in national boundaries but leaks out across global financial markets and into emerging markets. “Ultra loose monetary policy in the west,” says the HSBC paper, “has turbo-charged growth in emerging countries which tend to be more commodity hungry.”

And it’s emerging world growth that is driving the oil price – oil consumption in the OECD countries fell 7 per cent between 2005 and 2010. Yet global oil demand rose by almost 4 per cent over the same period, pulled upwards by a 20 per cent surge in the oil consumption in non-OECD developing economies. While the emerging world still only accounts for 25 per cent of total world GDP, it accounts for nearly half of the world’s oil consumption.

Meanwhile, the west continues to develop technologies that expand the search for new fields and enhance production from existing oil and gas discoveries. In the US the oil rig count rose to 1,994 during the week of 17 February, up 128 per cent from the week of 12 June, 2009, as new technologies revive old wells. The latest Oil Market Intelligence reports that US crude oil output rose to 5.87 mbd, the highest since March 2000.

Similar enhancement of recovery techniques in the North Sea could prolong the oil industry by another 30 years and put the UK back in a position to produce all the oil it consumes.

According to Jon Gluyas, professor of carbon capture and storage and geo-energy at Durham University, the process of injecting gas or liquid into the deep sandstones of the West Texas reservoirs similar to those found in the North Sea has increased output by 4.12 per cent, totalling around a billion barrels of oil. Capturing CO2 emitted by power stations and injecting it into the North Sea oil fields could increase substantially the amount of oil that can be recovered from these fields. “Applying such carbon capture and storage techniques,” says Martin Li in the Investors Chronicle, “would not only decrease the environmental impact of burning fossil fuels, but would also extend the life of the North Sea as an oil-producing region.”

Modelling enhanced recovery of 5 per cent from deep, high-quality reservoirs could, according to Gluyas’s calculations, see the North Sea producing an extra three billion barrels of oil. The CO2 emissions required to achieve this could be secured from the eastern part of the UK and injecting these emissions could “power” enhanced oil recovery in the North Sea for around 30 years.

Thus the spur of a higher oil price, problematic though it will be in the immediate term, could work to drive continued innovation and enterprise off the coast of Scotland. Depletion may not be as fast as we fear.