With economies in turmoil, oil prices must come down

This does not seem like a global economy that justifies oil prices above US$100 a barrel.
The US debt turmoil put a toll on crude as prices fell by more than 10 per cent in a week, and reached their lowest levels since November.
The US debt turmoil put a toll on crude as prices fell by more than 10 per cent in a week, and reached their lowest levels since November.

This does not seem like a global economy that justifies oil prices above US$100 a barrel.

Last week, stock markets around the world were routed and American investors lost $700 billion (Dh2.57 trillion) in a single day.

The US left it to the last moment to avoid default, causing its total public debt to jump above 100 per cent of GDP and the loss of its "triple-A" credit rating.

Debt premiums for Spain and Italy reached record levels as fears grew about the possible break-up of the euro zone. European shares fell to a 14-month low and UK second-quarter growth was negligible. Both the UK and US are enacting tough austerity programmes; both fear the dreaded double-dip recession. Even powerhouse Germany is slowing down as Chinese demand ebbs.

Forecasts for oil demand were sharply reduced. Barclays Capital, which predicted growth this year of 1.7 million barrels per day (bpd) just two months ago, has cut that to 1.1 million bpd. US oil stocks uncharacteristically grew during the summer driving season, typically a high-point of demand.

As a consequence of this turmoil, oil prices fell by more than 10 per cent in a week, and reached their lowest levels since November. If Libya were not still gripped by war and unable to export oil, prices would be lower still.

The view outside the US and western Europe is completely different - but just as troubling for the oil markets.

Three of the Bric countries are all showing signs of overheating. Brazil, China and India have all raised interest rates repeatedly this year, to try to tame inflation, now running at 9.4 per cent in India.

China has the tricky task of withdrawing its fiscal stimulus, cooling runaway economic growth and calming property prices without precipitating a slump. Soaring inflation, congestion, record low unemployment, rising energy demand, materials shortages and strong capital inflows epitomise the booming Brazilian economy.

In another major resource exporter, Australia, inflation is rising and a gap is opening between struggling manufacturers and the flourishing mining and petroleum sectors, which are short of workers.

Turkey grew a remarkable 11 per cent in the first half of this year and, like India and Brazil, is running a high current account deficit. And other Asian tigers, Indonesia and Vietnam, are facing high inflation and labour shortages.

These countries represent 65 per cent of global oil demand growth this century. The Middle East, whose own spiralling consumption was driven by the positive feedback of high oil prices, accounts for another quarter.

Developed economies still use more than half the world's oil, but their consumption has been falling since 2006.

The protracted process of deleveraging is likely to be accompanied by stagnation or at best anaemic growth. And, driven by environmental and security concerns, energy efficiency is improving: the Obama administration's recent tightening of vehicle standards could save 2.2 million bpd by 2025, about as much as the UAE exports.

The oil exporters are therefore entirely dependent on continued rapid growth in developing countries to support high prices. But growing inflationary pressures suggest these economies are running close to capacity. China is introducing new energy efficiency goals, and in both India and China additional gas supplies will ease the pressure on oil.

The GDP of Opec nations has risen 48 per cent since 2006; that of oil importers, just 9 per cent. This should clearly illustrate that oil prices of $75 or more, touted as "fair" for both sides, are nothing of the sort.

So there are two paths to lower oil prices. Production can increase, so easing inflationary pressures in emerging economies, and giving a boost to the struggling, indebted developed countries. Saudi Arabia and Kuwait have raised output, but there is little more short-term capacity.

Or, prices can remain dangerously high until they are brought down by recession and demand destruction, as in 2008. Then, a more fractious Opec would have to rediscover the unity of 2008 and again enforce production cuts.

Opec cannot disinterestedly regard economic pain elsewhere. The main GCC sovereign wealth funds hold some $1.4 trillion of assets. A 10 per cent drop in value precipitated by renewed recession would incur losses equal to more than six months of Saudi oil exports.

More seriously, having increased spending sharply and raised their break-even budget points to $80 per barrel or more, the oil producers have little room for manoeuvre. They have again allowed oil prices to surge too high, for too long.

With few short-term options, they now face a dilemma. They need to commit to new production to bring down prices to safer levels, but costly expansion projects, which will take three or four years to deliver, risk being stranded by a market slump. The worst decision would be to heed Venezuelan oil minister Rafael Ramirez's call for production cuts to keep prices unsustainably high for longer - the inevitable outcome not a soft landing, but a crash.

Robin Mills is an energy economist based in Dubai, and the author of The Myth of the Oil Crisis and Capturing Carbon

Published: August 8, 2011 04:00 AM

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