Fri, Mar 26, 2010 - Page 9 News List

Invitation to an energy calamity

By A. F. Alhajji

As rising consumption and nationalism in OPEC countries pushes down their crude-oil exports and forces international oil companies to invest in high-cost areas with small reserves as global demand continues to grow, oil prices might ultimately shatter the record set in 2008. In the short run, heightened volatility will be the rule, owing to economic, political, natural and technical factors. One has only to examine the recent past to see why.

While speculators can affect prices in the short run and increase price volatility, market fundamentals and government actions explain the spectacular rise in oil prices between 2003 and mid-2008.

During this period, world oil demand increased, mostly in developing countries, while production remained relatively flat from 2005 to 2008. The only way to meet growing demand was to use OPEC’s spare capacity and commercial inventories. Once spare capacity vanished and commercial inventories declined to critical levels relative to estimated future demand, oil prices started to break record after record.

Let us consider some details. First, world crude-oil production declined by 266,000 barrels per day (bpd) in 2006 and 460,000 bpd in 2007. Meanwhile, world oil demand increased by 1.2 million barrels bpd in 2006 and 937,000 bpd in 2007.

Second, the difference between actual output and what the markets expected magnified the impact of falling production. For example, forecasts at the end of 2006 predicted an increase in world oil production of 1.8 million bpd in 2007, but production actually decreased by 460,000 bpd. The market factored in the missing increase and thus reacted to a decline of 2.26 million bpd, not the actual decline of 460,000 bpd.

Third, OPEC’s crude-oil production fell by about 280,000 bpd in 2006 and 381,000 bpd in 2007, with a profound impact on prices. Most models, including those of the International Energy Agency, the US Energy Information Administration and OPEC itself, employ behavioral variables to forecast world oil demand and non-OPEC production. However, they do not apply the same method to estimate OPEC production. Instead, they simply assume that OPEC will supply the difference between estimated world oil demand and non-OPEC supply, despite the fact that OPEC can no longer compensate for a decline in non-OPEC production or for higher-than-predicted demand.

Fourth, lower production and increased domestic consumption drove down OPEC’s net oil exports by about 1.8 million bpd in 2006 and 2007, after increasing by about 4.8 million bpd between 2002 and 2005. Indeed, top oil producers are joining the top oil consumers with annual oil consumption growth rates above 5 percent.

Fifth, in the long run, a weaker US dollar decreases supply and increases demand. However, it seems that in the short run, the inverse relationship between oil prices and the dollar exists only under very specific circumstances, such as a crash in real-estate prices and volatile financial markets.

Looking forward, in the short run, speculators will continue to fuel oil-price volatility as bullish and bearish factors steer them one way or the other.

Economic recovery, a further decline in the dollar, low interest rates, weaker investment last year and various political factors are among the most frequently cited bullish factors, whereas weak and sluggish economic recovery, spare production capacity and high inventories are among the most cited bearish factors.

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