Whither oil prices?

There is no doubt that world-wide demand for oil is rising faster than any time in the last fifteen years. The American Department of Energy has just confirmed this trend in a report. The recent American economic recovery has contributed to this increase as well. American driving habits and low petroleum prices (the average price is $2 per gallon in the US while the same petroleum costs more than $5 in the EU) are also responsible for this excessive consumption of petroleum in the US. According to the May 2004 report of the International Energy Agency, demand for oil in the OECD countries is rising at a significant rate. Then , of course, we cannot leave this discussion on rising demand for oil without mentioning China and India. According to a recent Asian Bank for Development report, China alone was responsible for 35 per cent of increased demand for oil in 2003. This report also mentions that China has now replaced Japan as the world's second largest oil consumer.

On the supply side, one should take into consideration four factors, -- production, exportation, capacity of the refineries to turn crude oil into usable commodities for industrial and private use, and reserves under the soil. Although these factors are interrelated, they do not necessarily mean the same thing, nor do they have the same impact on the world's oil markets.

For example, according to the International Energy Agency, in the first quarter of 2004, Russia surpassed Saudi Arabia in oil production (8.93 million barrels per day (bpd) versus 8.21 million barrels per day). In April 2004, Russia produced 9.01 million bpd. Does this necessarily mean that Russia exports more than Saudi Arabia? No, because even though it has become the world's second largest oil exporter, Russia's pipeline export capacity is only 4 million bpd. Even though its economy is still not well-organised, thanks to its oil revenues, Russia's economic growth continues to outstrip the rates of growth of industrially developed nations. In order to catch up with Saudi Arabia, Russia needs to improve its pipeline export capacity. The US energy secretary, Spencer Abraham is currently holding talks with Russia's prime minister Mikhail Fradkov to find ways and means to improve Russia's pipeline and tanker capacities, for example, the Baltic pipeline system.

While Saudi Arabia, Kuwait and the Arab Emirates have some spare production and export capacity, refineries in the United States do not seem to have much spare capacity. A review of this capacity is now underway.

According to knowledge available today, the eleven-member-cartel of OPEC probably has close to two-thirds of world's "known" oil reserves. Of course, data about some of the reserves, like for example, the Russian and Alaskan ones may not be completely accurate. This may make a difference in the calculation of the world's real oil reserves. Saudi Arabia holds a unique position because of the fact that a full one-quarter of the world's proven reserves lie under its soil and that it is the only OPEC member which has got a spare production capacity of close to 1.8 million bpd which can be activated at short notice. Its cost of extraction is also relatively low. In other words, Saudi Arabia is probably the only country in the world which at the present moment can keep on producing approximately 10 million barrels per day and exporting the bulk of it for a considerable period of time. Because of these two circumstances, Saudi Arabia is in a unique position to influence world markets.

Although OPEC produces only 40 per cent of the world's crude oil, it is the world's largest exporter of oil . It also tries to manipulate prices by adjusting agreed output quotas. It is officially committed to producing 23.5 million barrels every day. The fact that OPEC (since the Gulf War, Iraq has been kept outside OPEC's quota system) produced 26 million barrels per day in March proves that its members were not very strict about their official commitments. In a way, it makes sense. Taking advantage of the high demand and high prices, they have tried to make some extra profits.

In an effort to bring down the prices by matching demand with supply, on June 3, OPEC, at a special meeting in Beirut, agreed to increase production by 2 million bpd in July and by another 500,000 bpd in August. Saudi Arabia , the Emirates, and Kuwait may decide to continue to add an extra million bpd unofficially, which will in effect mean a total OPEC production of 27 million bpd and over 28 million bpd , if Iraq's production is added to it. Now the question is: will this measure reduce oil prices? Temporarily, yes. But in the mid to long term period, no, because these measures will more or less bring the actual production in line with the officially authorised one. Even the Saudi oil minister Mr. Niamy was sceptical about it. He said to the Associated Press, "The prices are controlled by the market and are affected by many factors." So, what are these factors?

Besides demand and supply, there are at least four other additional factors -- speculation, fear of terrorism, strategic petroleum reserves, and high taxes on oil in the European countries -- which affect oil prices. According to some analysts, speculation and the fear factor have added a premium of between five and ten dollars. There has always been a certain amount of commercial hedging in the oil market. But poor performance of the stock market has pushed many financial speculators to take up long positions in the oil futures market. According to the International Energy Agency and the New York Mercantile Exchange, speculation in the oil market has never been higher, which is pushing up the prices. If the interest rates are raised before the presidential election in November, the speculators might move from the oil futures market to other investments with better return. If it happens, oil prices will suffer temporary turbulence and then steady.

However, despite assurances given by the Saudi authorities that, at any point in time, there are more than thirty thousand specially trained troops to guard the oil installations, fears of terrorist attacks in the form of sabotage to oil production and transportation persist. An exodus of foreign technicians may also slow down or stop future oil supplies. It seems, Bush's preventive war on Iraq to secure oil supplies has created just the opposite effect. It has created a sense of insecurity all over the world, and, in particular, in the Middle East. There is a fear that at any moment, oil supplies may be disrupted or stopped. This is the reason why, despite high oil prices, the American government and other governments are buying huge quantities of oil to build up, and in some cases, to increase, their countries' strategic reserves. According to some newspaper reports, the capacity of the US Strategic Petroleum reserve is now over 700 million barrels. This is artificially pushing up the demand for oil, and as a consequence, its price.

According to the International Energy Agency, today the world consumes approximately 80 million bpd, of which one quarter is consumed by the US. This agency also forecasts that by 2020, total world consumption will be over 100 million bpd. So, there is no doubt that for the next two or three decades the demand for this scarce commodity, which will inevitably run out one day, will continue to rise.

OPEC is scheduled to meet again on July 21, to review the impact of June measures to increase oil production. If by that time oil prices fall below $30, Iran and Venezuela, who opposed this increase, will most certainly ask OPEC to go back to its original quota of 23.5 million bpd production. Iran and Venezuela think that once the real reasons -- fear of terrorism and speculation -- for these soaring oil prices are removed, a glut of oil will lead to a sharp decline in price. This, in my opinion, is unlikely to happen because Saudi Arabia, which unofficially acts as the world's oil central bank will most certainly slash production to bring supply in line with the falling demand. Some OPEC officials still have nightmares about the "Jakarta syndrome" when, in 1997, oil prices dropped to $10 a barrel because of a glut of oil caused by overproduction in response to American pressure and a sharp decline in Asian demand. The House of Saud , which is reputed to have a special relationship with the House of Bush, may try to help Bush's re-election by maintaining the oil prices somewhere between $30 and $35, but most probably not below $30 because it will go against its own economic interests. In my opinion, even if the speculative bubble bursts, the security situation will continue to remain unstable. Therefore, the world should get used to the idea of paying for oil at a price which is likely to fluctuate between 30 and 35 dollars a barrel. The days of cheap oil are gone--perhaps forever.