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The hole at the centre of the global economy
From FNB
22 June 2006
Oil prices have been rising for three years now, from a low of $23 in 2003 to a recent peak of $75, averaging $40 in 2004, $55 last year and $65 so far this year.
These latest price levels are way above a reasonable long term sustainable level, driven by anxiety about the reliability of supply.
The irony of the moment, indeed of the entire three years of price run-ups, is that there has been no physical shortage of oil. And this despite conflict in the Middle-East and the impact of extreme weather conditions in the US and elsewhere.
According to the latest BP Statistical Review (June 2006), oil prices are high because spare capacity in the industry worldwide is low, and because too many of the key oil producing countries seem at risk.
The estimated spare capacity in the global oil market is 1.8mbd (million barrels daily). This is much lower than normal, with the global market preferring a cushion of 3-5mbd.
Specifically, this 1.8mbd buffer of global spare capacity is less than the individual production of either Iran (4mbd), Iraq (1.8mbd), Venezuela (3mbd) and Nigeria (2.6mbd). All these countries have been a source of market concern, with Nigeria these last six months for instance seeing reduced supply of 0.5mbd on account of violence.
This is why the world crude price and petrol prices at the pump are so high.
Besides concerns about oil prices, there are also longer term concerns about climate change and energy security, feeding global anxiety.
It will take time to expand the global spare capacity to 3mbd+ for there to be less concern of any single country incident (or series of events) overwhelming the global buffer, creating a real shortage and pushing oil prices shock-like to higher levels.
Much new investment is taking place (at least 11mbd of new global refinery capacity by 2010, most of it located in Asia). But the lead times for new projects is long, especially for refinery capacity, and global demand will continue to grow. Thus, it may take as long as 2010 to restore a more satisfactory global buffer capacity.
Meanwhile, one can speculate that one or more of these oil producing countries represent a bigger risk than the others in the global consciousness.
In particular Iran comes to mind.
If the disagreements between the US and Iran could be diplomatically resolved, possibly within months, an important part of the risk burden weighing on energy markets could be removed. By itself, this could mean that instead of residing at $70, the oil price could fall next year closer to $40.
On the other hand, UN sanctions of Iran, any Iranian retaliation, and at worst military exchanges in the region could lead the oil price towards $100 and beyond. Any severe disruption in any of the other risky producing countries could have a similar effect.
As to oil price prospects for 2007-2010, much appears to depend in the first instance on how US-Iranian relations proceed in coming months. Secondly, one would need to take a calculated view on events involving Iraq, Venezuela and Nigeria. The higher the oil price remains through 2010, however, the greater the erosion of growth in global oil demand, and the greater the incentive to boost new supply.
All this points to a likely restoration of a more adequate global spare capacity buffer beyond 3mbd by 2010. Unless, that is, any major oil producer including Saudi Arabia (11mbd), Kuwait (2.6mbd), UAE (2.7mbd), Algeria (2.0mbd), Libya (1.7mbd), Russia (9.6mbd) or Kazakhstan (1.4mbd) were to develop new internal problems eroding output.
Given the importance of energy at the centre of the global economy, and oil as its most pivotal element, we continue to run an enormous exposure to internal events in all these major oil producers for the next few years, for good or bad. At risk our global growth, inflation, interest rates, currencies, commodity prices and asset markets.
Better hope for good, because the nature of bad outcomes doesn't bear contemplation for the world economy's performance.
Original articles published at www.fnb.co.za.
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