June 9, 2008 4:15 pm

Insight: Oil will move higher

The fall in the oil price from $135 a barrel two weeks ago to $122 last Thursday encouraged those who are bears of the market to predict crude had peaked.

The subsequent spike to $139 shows they are wrong.

The declining dollar, the rhetoric of energy independence, increased energy consumption in oil producing countries, and power shortages in the Gulf States that are enouraging “private generation” are key factors that will push oil prices to new records. Add political instability in some oil producing countries, natural disasters, and technical difficulties around the world, and we are looking at an energy crisis in full bloom, with no end in sight.

Let us examine those key drivers in turn:

■ Dollar devaluation reduces oil supplies and increases the demand for oil. The result is a steady increase in oil prices. A prolonged decline in the dollar reduces the purchasing power of oil producing countries and increases the costs of international oil companies. As a result, the amount of money allocated for reinvestment in oil production declines. A decline in the dollar increases the demand for oil in countries with appreciating currencies and reduces the negative impact of rising oil prices on their economies.

■ Most Republicans in the US link oil to terrorism and call for energy independence. Democrats link oil to global warming and call for energy independence. Others link oil to dictatorship and call for energy independence.

The oil-producing countries would have ignored this silly rhetoric had it not led to billions of dollars in research grants and direct subsidies for corn ethanol, soy biodiesel, and other energy sources. The explicit intent of these policies is to replace oil, the life blood of these countries. Thus oil producing countries take the rhetoric of energy independence seriously. They are redirecting investment from the oil industry to energy intensive industries and other projects to export oil embedded in various industrial products. The effect is clear: slow expansion in oil production capacity and an increase in domestic energy consumption. Inevitably oil and gas exports will decline and world oil prices will increase.

■ Energy consumption in the Gulf region has exceeded all expectations. This massive and unpredicted growth has led to energy shortages. Almost all of the natural gas in most of the oil producing countries, including gas from unfinished projects, has been allocated to petrochemicals, production of electricity for local consumption, and various industrial uses. Since fuel oil supplies are also limited, use of crude oil in power generation has become an objective of policy makers who decided to subsidise heavy oil to make it competitive with natural gas in power generation. This trend means that the use of crude oil will increase over time. This increase will be at the expense of excess capacity and exports.

In addition, economic boom, population growth, higher income, and increase in the number of foreign expatriates have increased the demand for electricity dramatically in the oil producing countries. Power shortages in the Gulf will reduce oil exports as producers divert crude oil from exports to domestic power plants. Some countries will divert natural gas from reinjection in the oil fields to power plants, which will increase oil production costs and delay future oil production.

Power shortages have led to increased private generation, which is expected to increase yet more in the next two years. Recourse to private generation will create additional demand for diesel, fuel oil, and crude oil, which will also reduce the net exports of the region. Under such circumstances, oil prices will increase.

To conclude, the factors examined above are enough to push oil prices to new records this summer regardless of what happens in Iran, Nigeria, Venezuela, and the Gulf of Mexico or at US refineries, not to mention whatever surprises the future might hold. A reversal of some trends, such as an increase in the value of the dollar will reduce the pressure on oil prices, but it is not enough to bring oil prices down.

The writer is Energy Economist & Associate Professor at Ohio Northern University

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