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Crude oil prices have been at all-time records in October with markets convincing themselves that the once-unimaginable level of $100 per barrel may soon be achieved.

The Centre for Global Energy Studies is a leading authority on oil market analysis and oil price forecasting, and the economics and politics of energy. Julian Lee, senior energy analyst at the CGES, answered your questions on oil prices on Monday October 29.

Is the global demand for crude actually up, or is it just a speculative increase driving the market?
Shane Fitch

Julian Lee: Global demand for crude oil is actually up, although the extent of this year’s increase in demand is still subject to debate, not least because the year is not yet over.

We at the CGES belive that global demand for oil will increase on average this year by around 0.9%, about the same as last year. Others see much stronger growth, the International Energy Agency is currently forecasting demand growth in 2007 at 1.5%. Demand among the industrialised (OECD) countries is expected to contract in 2007, as it did last year, but this is more than offset by increases in China, the Middle East and some other developing countries.

Do you believe the current oil price is a result of a shortfall in supply?
Richard C, Edinburgh

Julian Lee: Global oil supply has been running below demand for most of this year. Typically, supply exceeds demand during the Northern Hemisphere summer and stocks of oil are built up. These stocks are generally drawn down over the winter months, when demand typically exceeds supply. In a ’normal’ year, global oil inventories would increase at a rate of around 1 million barrels per day over the summer months and be drawn down at a similar rate over the winter. This year, global oil stocks rose at an average rate of just 30,000 barrels per day and actually fell during the third quarter of the year.

In the past, most notably in the early years of the present decade, OPEC followed a deliberate policy of restricting its supply to keep the world short of oil. It argued that commercial oil companies did not need to hold such large (and expensive) stocks of oil because OPEC would vary its production to make certain that there was always sufficient oil available. Although it has not said as much, OPEC appears to be following a similar strategy at the moment, with a number of OPEC oil ministers arguing that the world is ’well supplied’ with oil and that OPEC will step in to offset any future disruption to supplies.

Could we be approaching the much quoted “peak oil” situation?
F Deely

Julian Lee: I do not believe that we are approaching “peak oil” in the sense that the oil resources in the ground are running out. Much has been made in some circles of an earlier front-page story in the FT, based on a report from the International Energy Agency, suggesting that the world faces an oil ’crunch’ in the next five years. This has been used to suggest that the world is running out of oil. In fact, the report did not say this at all; rather, it pointed to a lack of investment in additional capacity to get oil out of the ground, particularly in some of the large reserves-holding countries of the Middle East and elsewhere.

As oil prices have risen, so governments around the world have become much more nationalistic in their view of oil reserves. Rightly or wrongly, they have sought much more generous terms from potential investors in their oil sectors and in some cases have taken big steps towards nationalising their oil industries. This has created a climate of uncertainty in which investment decision have been delayed. Venezuela and Russia are both examples of countries where this has happened in recent years.

Also, with very high oil prices, there is much less incentive for a country to chase revenue growth by rapidly expanding its oil production, since it is already earning high revenues as a result of high prices.

Do you think only a recession will bring down the cost of oil or something even greater? Jeff, Ohio

Julian Lee: A recession does seem the most likely cause of a fall in the price of oil, unless OPEC ( the only producers who have any spare capacity) have a sudden change of heart and boost production quite dramatically in the coming weeks, which doesn’t seem very likely. As long as oil producers continue to deny that their actions are having any effect on oil prices, then the only movement can come from the demand side and the most likely cause of the sort of slowdown in demand that is needed to bring prices down is a recession, or at least a dramatic slowdown in the rate of global economic growth.

High prices are already having an impact on the rate of demand growth, though, even without tipping the world into recession. The rate of global oil demand growth halved from 2004 to 2005, falling from 3.8% to 1.9%. It halved again, to 0.9% last year and seems to have stabilised at that rate (in our view, anyway) in 2007. The problem is that global oil supply has been stagnant or falling since late 2005, largely as a result of OPEC’s output policy.

What role does the fall in value of the dollar play in the price of oil?
Eugene Brown, Chicago IL

Julian Lee: I think the fall in the value of the dollar plays a number of roles in the price of oil.

The oil-producing countries earn revenues that are determined in US dollars (if not always actually paid on dollars, because some countries - most notably Iran and Venezuela - have demanded payment in other currencies for symbolic, political reasons), but much of their expenditure on imports comes from countries in the Eurozone, or other areas outside the dollar zone. As the value of the dollar has fallen against these currencies, so the purchasing power of the oil revenues has fallen, leading to a need for more dollars (and hence higher oil prices) to meet spending plans. This leads to a higher target price for OPEC.

On the demand side, because the value of the dollar has fallen against the Euro, for example, the increase in oil prices in Euro terms is less than the headline figure. Add to that the fact that a large part of the price people pay for gasoline and diesel in Europe is a fixed duty that does not vary as the price of crude oil rises and falls, and the large increases in crude oil prices lead to only small changes in the retail prices of gasoline and diesel. It is these prices that consumers respond to. So the falling value of the dollar has helped to limit the size of the price increase in retail product prices in Europe and elsewhere, and as a result demand for these products has not been hit as hard as it has in North America.

The fall in the value of the dollar also has an impact on the paper markets and has been cited as one reason that so much money has gone into the oil futures market, which has been blamed for pushing prices up. All the analytical work that we have done at the CGES indicates that speculators follow price movements, but do not initiate them. However, once an upward price trend is established, the huge sums of money moving into the oil market probably exaggerate the upward movement.

How much of a factor has Russia played in the surging energy prices? What should Europe and other markets dependent on energy imports do in this regard?
Roman, Ukraine

Julian Lee: Russia has played a role in the surging energy prices to the extent that its production of oil has ceased to grow at the rate we became used to between 2000 and 2005. This does not appear to have been a deliberate policy on the part of the Russian government, although there have been some suggestions that the Ministry of Fuel and Energy sees an oil production rate of 10 million barrels a day as maximum target rate.

European and other markets dependent on imports should seek as far as is economically viable to diversify their sources of supply, both in terms of the mix of energy sources that they use and the suppliers and delivery routes that they rely on. For those countries that have previously benefited from artificially low energy prices (perhaps receiving oil and gas from Russia at well below international prices) the transition could be painful, but in the longer term diversity can bring greater security. However, because oil, in particular, is an internationally traded commodity and can be moved easily and cheaply around the globe, we are all affected by rises in the price of oil, no matter where we buy that oil from.

What do you make of the FT’s Lex column’s contention that a strike on Iran will lead to a lowering of oil prices, after an initial superspike?
Borzou Aram, London

Julian Lee: While a superspike in oil prices would undoubtedly accelerate the slowdown in demand in the US and probably undermine growth in Middle Eastern oil consumption too, it sounds rather like the medical procedure that successfully cures a minor problem, but kills the patient in the process. Yes, Iranian oil exports could be made up by other producers if they were suspended. However, a retaliatory attack on oil installations in the Gulf by Iran, or moves to close the Strait of Hormuz, or even just limit traffic through it could have such a huge impact on the volume of oil leaving the Middle East that we might all look back fondly on $100/bbl oil.

What, in your opinion, are the short, medium and long term trends in oil prices? Veeresh Narayan, India

Julian Lee: I think the short-term trend in oil prices is upwards. I don’t think there is a price equilibrium at the current level and OPEC shows little sign of putting more oil onto the market.

In the medium term, more refining capacity, in particular the capacity to crack heavy oils into light transport fuels should help to redress the balance somewhat and ought to start to bring prices back down again.

In the long term, there is now a groundswell of political and economic momentum behind alternatives to oil in the transport sector, even if we have not yet found a truly viable solution. High oil prices have contributed to this situation. Once an alternative is developed (second-generation biofuels from non-food crops currently seem the most likely route) then oil producers face a shrinking market for their crude with downward price pressures prevailing.

Of course, producers can buck these downward pressures, but only by sacrificing volume.

Would current oil price levels make the Arctic region a viable source for global oil supply? What is the minimum price level that would support the extraction of oil from this region?
Phalguni Soni, Vancouver

Julian Lee: Oil has been profitably extracted from the north coast of Alaska since the 1970s and has been produced at times when prices have been as low as $10/bbl, although such prices are nowhere near high enough to embark on new Arctic projects. To some extent the price needed to make such projects work will depend on the size of any reserves discovered and the difficulty of extracting them, beyond those associated with an Arctic environment. Russia’s Gazprom is scheduled to bring its first offshore Arctic oilfield into production next year, although start-up of the field has repeatedly been delayed and could be pushed back again.

Could oil at $100 per barrel cause a global recession and a stock market crash as was thought 10 years ago?
Abdul Karim Hammami, Riyadh/Saudi Arabia

Julian Lee: High oil prices could certainly be a contributing factor to a global recession. It is often argued that the economies of the industrialised countries, and perhaps of the world as a whole, are much less dependent on oil than they were in the 1970s and that they are able to cope with high oil prices. Indeed, some have argued that the current high (and rising) oil prices have had no impact on the global economy, where economic growth is still above trend.

The biggest danger in the past has been that high oil prices have quickly passed through to general levels of inflation, triggering higher interest rates and a slowdown in economic activity. During the recent run-up in oil prices there seemed to be little impact on inflation, the higher energy costs were not passed through to final consumers and everybody felt comfortable. Things have slowly changed though. Inflation has begun to rise as suppliers are no longer able to internalise rising energy costs and are passing them down the supply chain. We have seen a series of interest rate rises among industrialised countries.

Perhaps we should be looking at the oil price/economic growth relationship the other way around. Rather than assuming that high oil prices have had no impact on the global economy we should perhaps be arguing that part of the reason that oil prices are so high is that the global economy has been going through a period of strong growth. Once this phase of the growth cycle comes to an end and global economic growth starts to slow, we could see a dramatic knock-on effect on oil demand and, as a result, on prices.

If the price of oil rises to over $100 a barrel will alternative energy sources become more popular?
Junghong Lee, Kazakhstan

Julian Lee: I think alternative energy sources are already becoming more popular as a result of current price levels. Of course, it is not just current prices, but also the expectation of future prices that will have an impact on the popularity of alternative energy sources. If people think high oil prices will not last, there is less incentive to switch to something else that may soon be more expensive than oil.

It is often surprising that there has not been more of a response from the governments of oil-consuming countries to high oil prices. In the past, the US Vice-President has visited Saudi Arabia to urge the Kingdom to follow one or another oil policy, but there seems to have been no such pressure this time around. The conspiracy theorist in me says that the governments of the developed nations are quite happy to see high oil prices, as long as they don’t have a noticeably detrimental impact on the economy, because they help them with some of their wider political objectives. European governments have, to varying degrees, adopted climate change and a need to reduce carbon emissions as a central policy theme, while the US government has been pushing a policy of energy independence and reducing the reliance on imported oil, although it is also beginning to make similar noises to Europe about the environment. Both of these objectives (cutting carbon emissions and reducing dependence on ’foreign’ oil) can be justified much more easily to the general population if oil prices are high.

How will the rising price of oil affect the growth of developing economies?
Mommin Malik, Lahore, Pakistan

Julian Lee: I think developing countries are the hardest hit by high and rising oil prices. In many developing countries final product prices are controlled by the government to protect poor populations from steep price increases, but these subsidies become increasingly difficult to afford as oil prices rise.

There have been instances of product shortages in parts of China when domestic product prices have fallen far below those on the international market and Chinese oil companies have cut back on their imports. Elsewhere, Total has recently refused to import crude oil for the Indeni refinery in Zambia that it co-owns with the government after the Zambian government rejected a 25% increase in fuel prices requested by the company.

In China, there are very real fears that rising oil prices will increase inflation and destabilise the economy, which is reliant on its international competitiveness. Of course, there is one group of developing countries that is enjoying high oil prices and that is the oil-rich countries who have seen their incomes soar along with prices.

About the expert

Mr Lee joined the Centre for Global Energy Studies at its creation in 1989. He specialises in global oil market analysis and the oil industries of the former Soviet Union and sub-Saharan Africa, overseeing all the CGES’ work in these latter areas.

Mr Lee has written extensively on many aspects of the oil industry of the former Soviet Union, including the production prospects for both Russia and the Caspian region, the export options for oil and gas producers in both regions and the dynamics of and prospects for Russian oil demand. Mr Lee is a frequent commentator on global oil markets and on the oil industry in the former Soviet Union and the proposed export projects of Russia and the Caspian countries.

Mr Lee writes for the CGES on a wide range of subjects outside his areas of special interest, including the geopolitics of oil, the political and economic problems faced by major oil producers in the Middle East and general OPEC issues.

Julian Lee is also responsible for the CGES’ publication, ‘Oil Market Prospects’ and regularly contributes research-based articles and the oil market review and forecast section for the ‘Global Oil Report’. Julian also writes much of the ‘Monthly Oil Report’ and produces the CGES’ ‘Annual Oil Market Forecast and Review’.

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