September 11, 2008

What’s Happening to the Price of Oil, and How is It Affecting the World?


The big question

Why are we asking this now?

BECAUSE THE price has been bouncing around so much recently, although the general trend is firmly down. This week the value of oil dropped below the psychologically significant $100 per barrel mark for the first time since February, but it rebounded back up again yesterday following a surprise announcement from the Organisation of Petroleum Exporting Countries (Opec) that its 13 member countries are to cut production by more than half a million barrels per day (bpd). Apparently they're a little concerned about the rapid fall in price since its eye-watering peak of $147 in early July.

Why did the price go so high in the first place?

At $100 or so, it is 50 per cent higher than last year and 10 times its level of a decade ago. There are three main reasons it climbed so high. The most significant is simply demand. Not only are mature economies heavily reliant on oil - the US consumes nearly 25 million bpd, out of total global production of 86 million - but demand from developing countries is also ballooning. Although Chinese demand is currently a seemingly modest 8 million bpd, it is forecast to nearly double by 2015.

The second factor was the weak dollar, driving investors out of the Greenback and into fast-rising oil as a sure fire winner. Third, the absence of Iraqi supplies, for obvious reasons, and geopolitical concerns about US policy towards major producers such as Russia and Iran have pushed the price up.

Why has it since been coming down?

Since July, the dollar has strengthened thanks to better than expected growth figures. The fall-out from the credit crunch - threats of recession in a number of developed economies, and slower growth in China - is pushing down demand for oil. Yesterday, the International Energy Agency (IEA) cut its global demand forecasts for both this year and next, blaming a shift in consumer behaviour brought on by gloomy economic prospects. In the US in particular, the love affair with the Sports Utility Vehicle may finally be ending as drivers switch to greener alternatives and cut down on journeys.

Why does Opec matter?

Opec was established as a permanent intergovernmental organisation in 1960 to coordinate oil production policies, help producers ensure a reasonable rate of return, and ensure the stability of supply. In other words, it is a cartel. Discoveries of reserves in the North Sea and the Gulf of Mexico, along with the end of the Cold War and Russia's entrance into global markets, have diminished Opec's share since it first flexed its muscles with the quadrupling of the e price of oil in the first oil shock in 1973. But it is still overwhelmingly dominant and its members control around 40 per cent of all production.

The effects are real. Tuesday's oil price dip below $100 was on the strength of intimations that Opec was going to hold production steady. The announcement of a production cut late on Tuesday night sent prices up by around two per cent first thing the following morning.

What about the Russians?

The only really big non-Opec producer is Russia. Of the 86 million barrels produced globally every day, some 10 million come from Saudi Arabia, the world leader. But Russia's 8 million bpd is hard on Saudi heels, and dwarfs smaller Opec members like Nigeria. Over the decades, Russia and other non-Opec nations, including Norway and the UK, have sometimes provided a counterweight to the cartel's power by pumping more oil when Opec wanted to see production fall. But UK oil is running down, and Russian production has struggled in the last year - mainly because a lot of its reserves are in difficult places, like the Arctic, and politics has slowed talks with Western multinationals to bring in much-needed expertise.

There are also growing signs that Russia may want to cooperate more closely with Opec, largely because of their shared interest in keeping prices relatively high and a shared hostility to the US (Venezuela and Iran are Opec members). But Russia has its own self- interests overwhelmingly at heart, and geopolitical issues over what it considers its sphere of influence may stop the two collaborating too closely.

Why should this affect the UK when we have North Sea oil?

We used to be broadly self-sufficient, but not any more. For the past five years, North Sea production has been diminishing and the UK's oil imports have been steadily rising. In fact, numbers from the Office of National Statistics yesterday showed that the UK's trade deficit in oil hit its highest level ever in July. While the overall goods trade deficit shrank in July, the oil trade deficit almost doubled to 1.3bn.

Shouldn't falling oil prices mean lower petrol prices?

Yes and no. The good news is that petrol prices have already come down. The average price of a litre of unleaded has fallen from a peak of 124p in July to around 119p now. But today's prices are still considerably higher than the 104p per litre average petrol price when oil was last at $100 per barrel. One issue is lag It takes between four and six weeks for the cost of a barrel of oil to feed through to drivers. Another factor is tax. At current rates, a massive 68 pence worth of the pump price is duty, so even a big drop in the fundamental cost has only a proportionately small effect. And the fall of sterling counteracts the drop in the oil price, which is calculated in dollars.

What does it mean for the economyas a whole?

The widespread expectation is that, barring an unpredictable geopolitical event, prices will not return to July's levels. The latest Treasury forecasts are even for average oil prices next year to be around $93 - and if commodity prices come down, then so does inflation. Earlier this week, the latest factory gate inflation figures showed the pace slowing at last, with manufacturers reporting that their input costs actually fell in July, by 0.6 per cent.

If inflation comes down, the Bank of England has more scope to cut interest rates, in the hope of easing the worst excesses of the credit crunch and the related slow down in consumer spending. Although inflation is still expected to hit five per cent this autumn, David Blanchflower, a member of the Bank's Monetary Policy Committee, says it will soon afterwards "plummet like a stone", enabling the bank to cut rates repeatedly next year. Whether it is enough to save us from recession is the $60,000 question, with no immediate answer.

Will oil go back up to $150 a barrel?


*Demand is booming, particularly in the East, and will continue to do so

*Volatile geopolitics, such as the recent conflict in Georgia, add to uncertainty

*Speculators who smell a quick buck may push the price back up again


*Looming recession is putting the brakes on economies across the world

*Developed economies are working hard to become more energy- efficient

*Investors who were pushing up the price of oil are returning to the strengthening dollar

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