Oil-price decline? Maybe

July 14, 2008
High oil prices are certainly putting downward pressure on demand in the US and in other countries where the market is allowed to work, as opposed to countries that have fuel subsidies in place for consumers.

High oil prices are certainly putting downward pressure on demand in the US and in other countries where the market is allowed to work, as opposed to countries that have fuel subsidies in place for consumers. Some Asian governments, though, have recently removed or reduced their oil subsidies.

So, is widespread price-driven oil-demand destruction inevitable? And will prices fall?

Now that oil prices have reached record highs in both nominal and real terms, the International Energy Agency is looking at how these prices are affecting global economic growth and overall oil demand.

It is apparent that high prices are having an effect on demand, but it is important to look at how expensive oil has really become, IEA said in its June oil market report.

The agency finds that not only do global oil expenditures as a share of global gross domestic product remain lower than in the 1980s, but also oil intensity—the volume of oil required to produce a unit of GDP—today is half what it was in the early 1970s.

“At first glance, therefore, it would appear that the global economy is less vulnerable than in the recent past, even though oil prices have reached historically high levels. Yet to conclude that the current oil price rally is harmless would be misleading. Indeed, current oil prices will arguably have damaging and long-lasting economic consequences,” IEA says.

Oil prices are fuelling inflation both inside and outside the Organization for Economic Cooperation and Development. For the poorest oil-importing countries, higher oil prices will have a dramatic effect on income and development levels.

Oil demand is already stagnating or declining in OECD countries and in most of the world’s poorest countries. While some of the effects of high oil prices upon inflation, consumer spending, and growth are clear, the interactions are complex, the agency says.

IEA will continue an in-depth study of these issues and present the findings in its 2008 world energy outlook, due late this year.

Puzzling market

In his latest strategic brief, Michael Lynch of Strategic Energy and Economic Research Inc. observes that in spite of oil demand proving to be weak, with the macroeconomic news globally being very bearish, and with supply apparently growing—particularly in Iraq and Saudi Arabia—oil prices not only remain high but are setting records.

Lynch likens the current market to the one in 1997, when the Asian economic collapse weakened oil demand.

Despite terrible economic news in Asia and a currency meltdown in July 1997, oil prices continued to rise through September of that year, as markets focused on the dispute between Iraq and the UN over the oil-for-food program, and oil peaked on Oct. 3, 1997.

On Nov. 29, 1997, OPEC agreed to increase its production targets for the first time in 4 years, which led to an actual production rise of 500,000 b/d. The combination of weaker demand and greater supply eventually led to a huge inventory build and falling prices.

Slow to react

But it wasn’t until late in the year that prices declined even moderately, and market reports from that period suggest that observers were unconvinced that prices would decline significantly, Lynch says.

The oil market could face a similar scenario in 2008, he says, if demand in the second half of this year is weak, as looks likely, and if supplies move higher as a result of an increase in output from Saudi Arabia, a ceasefire in Nigeria, and recovery in Iraqi production.

The scenario would be especially likely if demand weakness occurs in areas where the data is reported late, such as non-OECD Asia, because then inventories could build strongly before markets react, suppressing prices longer than otherwise, Lynch adds.

With the combination of Saudi and Iraqi oil surging, the possibility of a restoration of Nigerian production, as well as rising OECD production, a significant and growing surplus could occur.

Two factors will determine the extent of the inventory build, Lynch says—whether the oil goes to the US, where it would be reported earlier, and how quickly lower demand in non-OECD regions becomes apparent. “And ultimately, how quickly the Saudis respond by cutting production will influence how far (and how fast) prices drop,” Lynch says.