Oil prices reached record highs in August and could keep going up. The reason is a combination of worries about terrorist attacks on oil infrastructure in the Middle East (including foreign experts and pipelines in Iraq and Saudi Arabia), political tensions in Venezuela (an upcoming referendum) and Russia (Yukos Oil), and on-again off-again labor problems and ethnic turmoil in Nigeria. There are also concerns about the ability of oil producers to meet upcoming winter demand. Furthermore, foreign workers must decide whether or not to return to Saudi Arabia after their summer holidays (we think that many will not for personal safety reasons) and terrorists could start to attack tankers (they have already attacked foreign workers and pipelines).

Although oil’s price increases may peak in the short-term, the global energy industry is in the throes of a structural transformation. On the demand side, the longstanding U.S. role of being the dominant consumer of hydrocarbons is being challenged by China. Since 1978, when China began its growth spurt, the Asian country shifted from being an oil exporter to a major oil importer. Not far behind China is India, also energy hungry. India’s real GDP growth is expected to be around 7 percent this year. Between China and India there are over 2 billion people, working and living in rapidly growing economies, with expanding middle classes with automobile-oriented consumer cultures. That means more oil demand.

At the same time as demand is on an upward swing, there is growing concern about supply, including the aging Saudi fields and their ability to meet global demand. Production is slumping in long-time OPEC member Indonesia, which in 2004 became a net oil importer for the first time in 100 years. In addition, supply from the OECD (Organization for Economic Cooperation and Development Countries) has probably peaked. Any additional oil to be squeezed is likely to come from Russia, Brazil (offshore) and Africa.

There is a growing possibility that we have made a structural adjustment to a period of higher oil prices - hanging in above the $30 a barrel market, possibly above $35 through 2004 and probably 2005. We would not rule out a spike to $50 a barrel, but that would be entirely related to a serious disruption of supplies from the Middle East. Barring any such disruption, oil prices should remain under $40 a barrel.

Previous cycles of high oil prices have usually ended in global recessions and ultimately lower oil prices that have hurt oil producers. Although we do not see a collapse of oil prices back down to the low $20’s in the medium term, it is in the interest of OPEC and other major oil producers to help manage a lower, more digestible price that does not kill global economic growth. Saudi Arabia is bringing on two new oil fields in the near future in an effort to bring prices back into line. Despite all of the oil being pumped, fear remains the dominant factor, with worry over sabotage and supply ruling the market. We don’t see this stopping any time soon.

© 2004 Dr. Scott B. MacDonald for KWR International, Inc,
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