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The high price of oil

Oil prices are already high, but even darker times could lie ahead.

In recent months, world oil prices have broken the $100 per barrel barrier for crude oil; it was only spring last year that the price of crude was around the $50 a barrel mark.

Goldman Sachs recently said: "$200 a barrel could be a reality in the not-too-distant future in the case of a 'major disruption'."

The reality of $200 a barrel by the end of the year is seen by some experts as unlikely, in part because OPEC (Organisation of Exporting Petroleum Countries) has been steadily increasing its production since December 2007. In fact, Western markets' inventories are steadily growing, and are expected to easily accommodate growth in consumption of 1.6 per cent. Chakib Kheli, OPEC's President, recently predicted that petroleum prices will range between $80 and $110 for the rest of 2008.

Some analysts have suggested that the oil markets should should not be experiencing the high oil prices of recent months, especially with the expected downturn in the world economy, increasing spare capacity and the slow down in demand for oil. Demand is slowing and the USA petrol consumption in January 2008 was 4 per cent down on January 2007, reports the US Department of Energy (USDOE). In China, growth in oil imports is easing, reports the International Energy Agency (IEA), from 10 per cent a year to 6 per cent. In addition, world surplus oil production capacity has risen from 1.5 million barrels a day a few years ago, to over three million barrels today.

Rex Tillerson, chairman of Exxon Mobil says the record run in oil prices is related more to speculation and a weakening dollar than supply and demand. "It's pretty crazy," he said at a recent press conference at the New York Stock Exchange. He argues that a weak dollar accounts for about a third of the recent record run, another third on geopolitical uncertainty, and the rest on market speculation. Despite the concerns about political instability hurting oil supply, history suggests that supply disruptions are quite rare. "In terms of fundamentals, fear of supply reliability is overblown," Tillerson said.

In dollars, the price of oil has jumped dramatically. This is partly due to the 30 per cent drop in its value against major currencies since 2002. Measured against the Euro the price of oil appears less dramatic.

According to Daniel Yergin of Cambridge Energy Associates, the price of oil for Europeans is still roughly what it was last year.

Clearly, while the high price of oil reflects the present short-term situation, in the long-term other considerations play a part.

A very important influence is the geo-political situation, such as the tension between the USA and Iran, the security situation in Iraq, and talk of imposing sanctions on the Sudan.

Contributing factors

Away from the oil fields, there have been problems including strikes, insufficient refining capacity and the weather conditions that have contributed to recent price increases as well as the seasonal needs of the Northern Hemisphere to build up its inventories to prepare for the upcoming winter season when demand will peak.

Another long-term factor is the skills gap, particularly for engineers for it has been forecast that in the next decade more than half the industry's employee base will retire. "There has never been a time when our industry so needs outstanding talent," Tillerson adds. "It can take up to ten years to train specialised workers."

Production is lessening in some oil producing states such as Iran and Venezuela, as a result of management failures to undertake the necessary investment over the long-term, to maintain production, observes Robert Mabro of Oxford Institute of Energy Studies (OIES).

In terms of the financial markets, oil has been experiencing a series of record highs since last October as investors have fled stock markets and taken refuge in dollar denominated assets. Speculators in the world's leading commodities markets such as the London International Petroleum Exchange and New York's Mercantile Exchange do not solely consist of oil producers like OPEC or oil companies.

Increasingly, speculators such as merchant banks, hedge funds and investors are using the futures market as a hedge or bet against inflation and a declining dollar. The trouble is that much of the speculation is dependent on data which is often inaccurate. In other words, the oil market is starting to resemble the gold market (which has also been soaring). It is clear investment flows into the oil market that do not have anything to do with the demand and supply of oil. Such increasing speculation in the futures markets adds pressure for the price of oil to increase in dollar terms, in both the short- and long-terms.

The future price of oil

Perhaps the most important issue is the impact dramatic oil price increases have on the world economy?

For G8 countries like Britain, the impact is likely to be less severe than the first oil price shock in 1972-73, when the price of petroleum quadrupled. However, it can be argued that the jump in oil prices magnified existing economic troubles rather than were the primary cause of economic problems.

An argument, curious or ironic, that can be made is that the UK is benefiting from high fuel taxes, because nearly 70 per cent of the price of a litre of petrol is made up of fuel duty and VAT. Taxes act as a cushion against major oil price fluctuations. The proportional increase will be less than in low fuel tax countries like America where the tax is around 20 per cent of the price at the pumps.

If we experienced a similar price shock today, then adjusting for inflation we should be experiencing oil prices around $200 per barrel. Luckily, for Britain the impact of high oil prices should be less severe on the economy. It will be external problems like the US 'credit crunch' which will determine how the British economy will be affected.

For British industry, October is an important month as 60 per cent of firms buy their forward contracts for energy. By then, oil prices should have fallen.

Dr Adnan Shihab-Eldin, OPEC's President, has pointed out that "predicting the price of oil is extremely difficult. Not only must one take into account the fundamental factors, like supply and demand, but one must also anticipate the non-fundamentals, like geopolitical tensions and possible supply disruptions".

According to the United States Department of Energy, in the short-term the price of oil is likely to fall due to a slowdown in the American economy, reduced consumption of oil caused by high oil prices, and increased OPEC production since December 2007 that has led to increased world oil inventories. The threat to supplies from a war between the USA and Iran has decreased, while supplies from Iraq continue to improve. The question is, when will reality permeate into the oil futures market?

What lies ahead?

In the longer-term, most analysts agree that the price of oil is likely to continue its upward trend, but how fast it will climb will depend on how fast world demand may increase, plus the usual security, technological, economic and political factors, plus the decisions of the futures market.

A further unknown variable is the extent to which new fields will be opened up. Already, some OPEC countries are nearing the end of their ability to export surplus oil, due to internal political and management problems.

However, others are investing in new technology and engineers to boost and extend the life span of existing fields. New methods of exploration including increased use of 3D seismic data have reduced drilling risk and led to the discovery of fields in the Arctic Ocean. Also, directional and horizontal drilling has improved production in many oil fields, and new recovery methods have enhanced existing oil wells.

In addition, there is the declining ability of OPEC to determine the price of oil, in part because of the influence of speculators in the London and New York Futures Markets, but also increasing disunity among its members who seek to maximise income in the short-term by stepping up production above OPEC quotas.

In Britain, the recent decision of the government to implement a nuclear power station program, on the scale of the French, is likely to mitigate the UK's dependence on oil as an energy source. As for OPEC, its power to determine the future price of oil is likely to continue to wane, as the rise in the power of speculators to influence prices continues unabated. Elsewhere in the world, exploration and development of new oil fields outside the often politically unstable OPEC regions, is likely to gather pace, especially if current high prices are maintained. The very same high price levels are likely to further encourage governments to develop alternative energy sources.

For engineers the opportunities for work and innovation in the energy sector look bright.

The Arctic seems to be offering the prospect of new opportunities to explore and develop that are free from the political instability of the Middle East.

Big gas discoveries have already been made off the South Kara/Yamal and East Barents Sea and across most of Arctic Canada. The best oil potential may be in the Pechora Sea, Baffin Bay and on the North Slope, although several other basins could become attractive.

What might be the break-even price of extracting these reserves? It's estimated that 400 billion barrels of oil equivalent gas and oil reserves still remain.

How ironic it is that global warming should have an upside as, while the Arctic ice caps continue to shrink, this is making it much easier and economic for the world's oil companies to explore and develop new oil fields, in regions which until now had been at the frontiers of technology and costly to exploit.

Developments off Norway's North Cape, Russia's Stockman fields and Alaska's North Slope are just the beginning and it is likely, in the near future, with the melting of the ice cap such developments in the high Arctic will be common place.

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