IT takes a plucky writer to admit he is wrong, particularly when there is a
certain type of reader out there – usually anonymous, sometimes using
joined-up writing – who is happy to tell me I am wrong every week.
But I have been wrong, so far at least, on oil. High oil prices, one of the
factors that have complicated the task of the Bank of England and its fellow
central banks, are still with us, having climbed back above $70 a barrel in
recent weeks. Last week they remained close to that level. Futures markets
suggest $60-$70-a-barrel oil for the foreseeable future.
My hopes were raised earlier this year when prices dipped briefly below $50 a
barrel, not far above the $40 level I had said was sustainable in the
long-term. But the market was just teasing, and prices were soon on their
way back up again.
So this is a good time to revisit oil, and to ask the question: Will prices
ever come down again?
America’s “driving season”, which traditionally begins on Memorial Day (last
Monday), is a key date in the oil season. Last summer, high prices had the
effect of curbing so-called VMT (vehicle miles travelled) in America and
prevented the usual seasonal rise in demand that occurs as the weather warms
up.
With petrol prices having spiked higher again, something similar may be in
store. Higher prices do have an effect – American carbon emissions fell last
year.
So what has been pushing up oil prices? International tension, whether it be
the Iraqi insurgency, violence in Lebanon or Gaza or American warships
patrolling off Iran, appears to be ever-present.
With 62% of the world’s “proved” oil reserves in the Middle East, this is an
uncomfortable backdrop. Tensions in the region are worth, on reasonable
estimates, $10-$15 of the current price of crude oil, maybe more. The big
one, of course, would be a serious Saudi insurgency, with attacks on the
world’s biggest producer’s oil installations. Some attacks have been
thwarted by the kingdom’s security services this year.
Tension in the Middle East is one thing but turbulence in Africa has had a
more direct effect on oil output. Political unrest around Nigeria’s
presidential election and the activities of militants in the Niger Delta,
who specialise in kidnapping oil workers, have combined with technical
problems to cut production, at times by 800,000 barrels a day, though a
strike was called off last weekend.
There are other important factors. One reason American motorists are starting
the driving season with petrol prices of well over $3 a gallon (40p a litre)
is the high price of crude. But equally important is the chronic shortage of
American refinery capacity. No new refineries have been built since the
1970s and the oil giants have been fighting congressional allegations of
“price-gouging”, in other words profiteering.
These are all important factors, and there are others. Hedge funds moved money
out of oil earlier in the year but have come back in. Investment demand has
helped to boost prices.
The two most important reasons for the strength of oil prices, however, lie
elsewhere. The first is the strength of the global economy. More than a year
ago, the International Monetary Fund (IMF) spoke of an “extraordinary purple
patch” for the world economy. At that time the global economy was enjoying
its third successive year of roughly 5% growth, its best run since the early
1970s.
The thing about purple patches is that they tend to be temporary. My
expectation of softer oil prices was partly based on a softening of global
growth, perhaps only to 4% but enough to make a significant dent in oil
demand.
But that has not happened, despite weaker growth in America. The world is
still growing at 5%, for the fourth year in a row, and forecasts from the
IMF and OECD suggest something like this will continue next year and even
beyond it. World economic growth of 5% does not mean a 5% rise in global oil
demand but, according to the International Energy Agency (IEA), it does mean
a rise of 1.8% this year, after 1.3% last year. The global economy would
need to slow to below 4% to flatten oil demand. That is possible at some
stage, but for the moment there is plenty of momentum. Some oil-price bulls,
curiously, were growth bears, which never looked very rational.
Demand is one factor, supply the other, and here the finger has to be pointed
firmly at the Organisation of Petroleum Exporting Countries (Opec). The
cartel has got its act together, cutting production, ostensibly to put a
$60-a-barrel floor under prices, in practice to keep prices well above that.
The IEA estimates that Opec production, at just over 30m barrels a day, is
3.7m barrels below its sustainable capacity. Four years ago Opec was happy
to keep oil prices in a $22-$28 range. Then it said it wanted to protect
$50; soon it could be more than $60.
Is Opec, dominated by the Arab oil states, being greedy? Yes. I wish I could
say they would suffer for it. But as long as the world economy is strong,
evidence of “demand destruction” – collapse in demand for oil that would
push down prices – is hard to detect. Some Opec members would no doubt blame
western intervention in the Middle East for high prices.
So what will happen? There are three possibilities. One is that it is onwards
and upwards for prices, each increase in international tension interacting
with tight supply to push us to $80, $100 or beyond. The other is that
$60-$70 is the new sustainable level and that, as the futures markets imply,
we will stay there for some time. The third possibility is that prices will
drop significantly again.
I would still argue, based on the history, that this is too high and that at
some stage, as has always happened in the past, prices will drop
significantly again. But some oil price spikes are short, no more than a
year or two. Some last longer. You could argue that we were in a continuous
spike from 1973 to 1985. This one is getting longer by the day. Until demand
weakens, it will continue.
PS: How worried should we be about a “back to back” rate rise from
the Bank of England this week? We have been warned by both the Bank’s latest
inflation report and the minutes of its May meeting that at least one
further rise is on the way. Those interested in historical parallels will
note that the last time it happened was exactly three years ago, in May and
June of 2004.
The minutes suggested the reason nobody on the monetary policy committee
(MPC) voted for a half-point rise last month was because even those members
who toyed with it were unconvinced and wanted time to assess the effect of
rate rises so far. Other members stressed the need to move cautiously on
rates, while a third group was concerned about triggering a downturn in the
economy. None of this suggested much of an appetite to move again quickly,
though people’s perspectives change, even over a month.
The “shadow” MPC, which meets under the auspices of the Institute of Economic
Affairs, has also been deliberating. It has been more aggressive than the
actual MPC, four of its members urging a half-point rise last month.
This time, the shadow MPC has one “half-pointer”, the former dove Roger
Bootle, who thinks the shock therapy of an immediate move to 6% is needed
because “the stakes are too high to be pussy footing”. Three other members
of the committee – Tim Congdon, Andrew Lilico and my namesake David B Smith
– all want a quarter-point hike this week.
Bootle said there is a danger inflation will get out of control. Congdon now
believes the likely peak in rates will be 6.5%, attacking the Bank’s
analysis of the relationship between the money supply and asset price
inflation as “useless”.
These four were, however, outvoted by five others, Kent Matthews, Patrick
Minford, Peter Spencer, Peter Warburton and Trevor Williams. Even if they
are right this week, however, the Bank will still have to hike again – all
four of the hikers and two of the “holders”, Spencer and Williams, have a
bias towards further tightening.
david.smith@sunday-times.co.uk
