Why global oil prices are rising

Oil is a major source of energy the world over. When energy (read oil) is available at low prices, the outlook towards growth is optimistic and vice versa. Crude oil prices have been rising continuously since 1998, when the price was $10 a barrel.

Since the death of the King Fahd of Saudi Arabia on August 3, crude oil prices have crossed $60 a barrel. Recently, crude prices crossed $70 a barrel as the hurricane Katrina hit the United States and brought production in the Gulf of Mexico to a halt.

All this has led to talk of sustained high prices in the days to come. But, as history tells us, oil is a cyclical business: prices go up only to come down again. So the question that needs to be asked is: why have oil prices been going up and will this increase continue in the days to come?

The oil cartel

Since the mid-eighties, the Organisation of Petroleum Exporting Countries (OPEC) has been acting as a swing oil producer of the world. That is, OPEC produces only to fill the gap between global oil demand and production by non-OPEC countries.

Over the years, the swing production arrangement resulted in OPEC having a lot of idle capacity. This helped OPEC to gain control over oil prices. Whenever the inventory level of oil stocks in industrialised nations, particularly the members of Organization of Economic Cooperation and Development (OECD) went up, OPEC reduced output.

This artificial scarcity that OPEC manages to create did not allow oil prices to fall.

The same idle capacity has been used to pump extra oil into the market to prevent dramatic price rises during times of unexpected supply interventions. Most of this idle capacity is in Saudi Arabia, the largest member within OPEC.

The country has effectively used its idle capacity in the past to prevent any price increase during the Iran-Iraq war, the Gulf War and the recent Venezuelan crisis.

But that situation seems to be changing now, with OPEC unable to control the surging global oil prices. OPEC members have been pumping oil as fast as they can with hardly any idle capacity left. Saudi Arabia is the only country that has some spare capacity left. The idle capacity stands at just 0.5 million barrels per day (mbpd) as against 3 mbpd few years back.

So even though there is no shortage of crude oil, the fact that there is no safety net, has made the oil traders jittery. This has led to them demanding a risk premium and so the high price.

Political instability

Most of the known oil reserves are in one part of the world, i.e. West Asia (or the Middle East). The other major petroleum exporting countries are Russia, Nigeria, Indonesia and Venezuela. These countries have been politically unstable in the recent past and this has also led to the oil traders demanding a premium.

Global demand led to oil shock

The main reason, however, for the oil price hike is surge in global oil consumption. The global consumption of oil went up by 3.4% last year. Most of this increase has come from China. China's oil demand grew by almost 16% last year. Although demand has not grown at the same rate this year, as China progresses and more and more people buy cars, China's demand for oil will go up.

And the fact that China is a net oil importing country, its demand for oil will add to the world demand for oil.

But the consumption of oil in the United States remains the biggest reason for this sustained growth in the global oil demand. The US, which has just 5% of the world population, consumes one quarter of the global produce. The oil efficiency of vehicles in the US has now fallen to a 20-year low. Its energy policy does very little to ensure greater fuel economy in cars or sports utility vehicles.

Further, as developing countries keep improving their standards of living (China's oil consumption per person is around one-fifteenth that of America), and automobiles remain a symbol of aspiration, there is only one way where the oil price is headed: upwards.

Also what needs to be understood is the link between oil prices and interest rates. Interest rates the world over have been very low and this, in turn, has led to increased consumption. This, in turn, has led to an increased demand for oil and thus the increase in oil prices. If the prices are high because of high demand they will stay there for much longer.

This was not the case when the world went through supply-led oil shocks, where once the supplies were restored prices fell.

Speculation

Another reason for the northward movement of oil prices is speculation. Some oil experts have recently talked about oil prices touching even a high of $100. If something like this does happen, it will create havoc in the equity markets.

As oil prices go up, energy costs will rise and the cost of doing business will go up. This, in turn, will affect the profit of companies. So big equity funds the world over are investing in oil futures (buying oil futures to buy oil) to hedge against the risk of the value of their other investments falling.

Pension funds have also made a beeline and have poured in a lot of money into securitised investments in oil. This has led to sustained high prices of oil. The fact that OPEC has reiterated time and again that it will not allow prices to fall has helped these speculators.

All the above reasons seem to suggest that oil prices are on their way up. How many dollars a barrel, only time will tell.

The counter argument

Oil revenue is the major source of income for West Asian countries, particularly Saudi Arabia. Also there are the huge oil reserves in Saudi Arabia as well as West Asia. Given this, the Saudis will not want oil prices to stay high for too long. A continuous surge in oil prices may affect their revenue as it might lead to investors putting their money into non-OPEC oil and other alternative fuels.

The assumption in this logic is that West Asia is sitting on huge oil reserves. But there are numerous oddities about the estimates of the West Asian oil reserves.

Even though a lot of production of oil has happened, year-on-year figures of oil reserves have been constant. For example, Saudi Arabia, reported insignificant changes in its oil reserves during 1980-89. Then in 1990, the reported figures showed that its oil reserves had grown by 90 billion barrels (equivalent of 3 North Seas -- one of the biggest non-OPEC oil reserves in the world).

Similar is the case with Iran and Iraq. Why does this happen? This is because of the way OPEC operates. The production quotas for OPEC members are determined by their production capacity and the production capacity is determined by reserves the member country has. So it might turn out to be that OPEC has a lot less oil left than it claims it has.

Alternative fuels

It is said that transportation is the only sector still critically dependent on oil. But that dependence might come down in the decades to come with the development of other technologies like fuel cells. Most of these alternative fuels are not commercially viable as of now. But they might be if oil does touch $100 a barrel, as is predicted.

Besides, with development in the oil extraction technology, the reserves, which were earlier considered to be too expensive to be drilled, may become economically viable. Oil majors are investing in these technologies. After all they need to survive in the market.

The road ahead

Governments, the world over, need to put in place energy policies that curtail the demand for oil. Also alternatives to oil need to be seriously encouraged. Brazil has seen an interesting experiment where ethanol mixed with petrol is used.

Oil prices have certainly reached a point that was not even dreamt of a few years back. In the short run, oil prices -- as the current evidence suggests -- will remain high and what happens after that, well your guess is as good as ours.