High oil prices have impact on Middle East

Posted in Other | 29-May-04 | Author: Herman Franssen| Source: The Daily Star (Lebanon Edition)

VIENNA: Until a few years ago, oil analysts agreed that the long term equilibrium price of oil was somewhere in the vicinity of $20 a barrel, because at that price most oil resources in the world could be profitably extracted.

The theory went that if prices stayed much above this level for a few years, oil demand would fall, and non-OPEC oil production would rise. This would make OPEC's task to manage global oil supplies difficult and prices would fall. Since 2000, though, oil prices averaged 40 to 50 percent above the long-term equilibrium price. Today, oil prices are a full 100 percent higher.

Instead of demand falling, global demand this year is the strongest in a decade, largely due to China's booming economy. Despite the high prices, growth in non-OPEC production outside Russia has been disappointingly modest.

The booming global economy is not the only reason for high oil prices this year.

High oil demand has revealed how tight the entire global oil supply chain is - from the wellhead to the consumer - due to years of underinvestment.

With the exception of Saudi Arabia, there are very few other countries with significant spare capacity. Hence, even modest supply disruptions in the Middle East, Africa or elsewhere immediately result in higher prices.

A total cut of all Iraqi oil exports (some 1.8 million barrels per day) in today's market could move prices in the direction of $50 per barrel until the IEA and producers with spare capacity react to the crisis.

Refining capacity, in particular in the United States, where different regions require different gasoline specifications, is also very tight. In order to maximize production of gasoline, refiners are willing to pay a premium for light oil. Also, any refining accident in the US that results in lower gasoline production is immediately reflected in higher prices at the pump.

Both crude oil and oil product stocks in much of the industrial world and the industrializing giants of Asia are low by historical standards, adding to market pressures.

The impact of a tight tanker market became apparent last year during the Venezuelan supply disruption, when short-haul Venezuelan crude had to be replaced by long-haul oil from the Middle East.

Finally, hedge funds and other speculators are long in the paper market, adding several dollars to the price of oil. If all these factors were not enough, the uncertain geopolitical outlook in the Middle East has added further pressure on prices.

Forty dollar oil not is not in the short or long term interest of the Gulf OPEC members, and Saudi Arabia has pledged to do what it can to bring prices down by promising to increase production by as much as 1 million barrels per day in June. This pledge was made less than a week ago, but the reactions in the market have been disappointing, perhaps in part because the reaction among other OPEC countries has been mixed.

At the next OPEC meeting in Lebanon in early June, OPEC will have to decide if the organization as a whole favors following the Saudi example.

The few (mainly Gulf producers) who have spare capacity are probably going to follow the Saudi example, but most other members may not be able to increase production because they are already at capacity.

From a purely technical point of view, the added Saudi production alone is more than adequate to meet global demand in the spring and summer of this year, and to add to low OECD commercial stocks.

Time will tell if the higher oil production is going to lead to returning oil prices to the high $20s, where major OPEC members want them to be.

OPEC's problem is to carefully balance perceived market fundamentals and market psychology. Most oil analysts expect that Saudi policy will work and prices will be coming down in the weeks to come, provided the geopolitical situation in the Middle East does not worsen and no other supply disruptions occur.

In the short term, the higher oil price environment since 2000 has been beneficial for OPEC and for the Gulf region.

OPEC oil income had already risen from a low of $115 billion in 1998 to $242 billion last year, and 2004 may prove to be even better. Saudi oil income rose over the same period, from $36 to $81 billion, and probably higher this year.

Will the oil boom last?

If the world economy continues to grow at close to the current rate next year, oil demand may rise by another 2 percent, leading to additional demand for OPEC oil of perhaps 1 million barrels per day.

OPEC and in particular Saudi Arabia will have to prove to the world that they are skillful and prudent manager of global oil supplies. If Saudi Arabia succeeds in its current efforts to reduce oil prices to more sustainable levels, the global economy will not suffer and oil producers may look forward for one or two more years of higher than average oil income.

Herman Franssen worked for the US Department of Energy, and was chief economist of the International Energy Agency in Paris and senior economic adviser for the Omani petroleum and minerals minister, and is currently president of International Energy Associates in Washington. He wrote this analysis for THE DAILY STAR