Thirst for oil will keep prices high

A quarter of retail fuel sales are subsidised. This means that there is little incentive for businesses and consumers to cut consumption

WE'RE all being affected by the rise in global oil prices. The big question is whether the recent rally is caused by an imbalance between global supply and demand, whether it's the result of speculation, or both. Oil prices have doubled over the last 12 months even though global demand growth has slowed.

How do we explain this? Let's look at the evidence.

Crude oil supply growth has been disappointing, and has had a hard time catching up with demand. From 2002 to mid-2005, supply rose by some 12%. Since then, however, supply growth has been much slower.

According to the 2007 BP Review of World Energy, global oil production fell by 0.2%, or 130,000 barrels per day (b/d) in 2007, the first decline since 2002. Opec production declined by 350,000b/d.

While the global rig count stands at its highest level since the oil boom in the mid-1980s, production growth outside Opec remained weak, rising by 230,000b/d in 2007. Investment spending by oil producers has been strong, but rapid cost inflation has eroded its real value. Day rates for deep-water drilling ships are up to US$600,000, if they are available at all. The shortage of skills and equipment has delayed many projects.

Moreover, drilling opportunities for international oil companies in the US are severely restricted. There are considerable reserves in the West, Alaska and offshore. These areas hold an estimated 635 trillion cubic feet of recoverable natural gas and an estimated 112 billion barrels of oil. The vast oil sands are economically viable, even at prices lower than those prevailing today.

Opec, which still controls the lion's share of proven reserves, has proven reluctant to boost production or capacity. Restricting supply means higher prices. National oil companies (NOCs) are reasserting themselves, as high oil prices have shifted the balance of power.

The issue is not a physical shortage of oil – there is plenty of oil in the ground – but a shortfall of investment because of resurging resource nationalism and geopolitical instability. As a result, capacity will remain well below the level that would be achieved in a competitive and developed market given current high prices.

Price has also been driven up by the fact that global demand increased by one million barrels per day in 2007. Globalisation is a thirsty business. There is less heavy lifting from the US consumer and more from energy-intensive activity in emerging markets, meaning that overall global growth is becoming more energy-intensive.

Resource-rich economies in the Middle East have experienced rapid increases in crude oil demand. Saudi Arabia in particular has become a major energy consumer as it embarks on a strategy to perform more of the higher value-added activity at home.

Foreign exchange inflows have allowed the kingdom to undertake significant investment spending in petrochemicals, aluminium and fertilisers. Consumption in the oil-exporting regions of the Middle East, South and Central America and Africa accounted for two-thirds of the world's growth in 2007.

High oil prices should reduce demand where market forces are allowed to work freely. The biggest challenge here is subsidies. About a quarter of global retail fuel sales are subsidised, mainly in emerging markets. This means that there is little incentive for businesses and consumers to curtail consumption. That said, China has just increased retail fuel prices by 18%-25%. Subsidised petrol and diesel led to heavy losses for refiners and to domestic fuel shortages. These increases will have a significant effect on demand, even if fuel prices remain well below the global level.

Nevertheless, the main burden of adjustment has to be borne by developed economies. Indeed, high prices have already started to curtail consumption (where market forces are allowed to work). In the US, demand growth turned negative for the first time in 17 years. It is down 1% for the first half of 2008. Other OECD countries have seen even stronger responses: consumption fell 2.6% in the EU, 3.5% in Japan and 9% in Germany in 2007. In contrast, China's consumption increased by 4.1%.

Institutional investors have discovered commodities as an asset class in their own right, which has added to the value of oil. While other asset classes are doing poorly, low yields have undermined the attractiveness of fixed-income securities, while volatility impacts the attractiveness of other financial assets. In this environment, commodities appear to offer attractive returns, especially if past increases are extrapolated into the future.

There is no question that the inflow of funds into commodities over the last few years has been substantial. Inflows of index funds into the commodities segment increased from $13bn at the end of 2003 to $260bn by March 2008. Over just five years, assets have increased twenty-fold in a market that is still dwarfed by global equities.

In addition, as the dollar has weakened, global commodities prices have increased. A weaker dollar makes oil and other commodities priced in dollars less expensive for buyers paying in other currencies.

A weaker dollar also makes investments in commodities an attractive inflation hedge. With rising inflation, demand for commodities rises, which drives up prices for commodities, which then drives up inflation further – a cycle that feeds on itself.

To sum up, the oil market will continue to be dominated by demand and tight supply.

Thorsten Fischer is senior economic adviser at Royal Bank of Scotland