Have we reached the end of the road for oil?

LONDON, Aug 10 — With the oil price apparently in full retreat, it is tempting to breathe a sigh of relief. After soaring to an all-time high of more than US$147 (RM485.00) a barrel in mid-July, the cost of crude has dropped by nearly US$30 in the last four weeks.

Although the price is still more than 10 times higher than a decade ago, some analysts are now talking of a "tipping point'', predicting a continued slide to US$90 a barrel. So why has a commodity that until recently seemed like a one-way bet suddenly gone into reverse? And having helped push the economy to the brink of recession is the oil shock over, or merely in remission?

One thing is almost universally agreed upon: the recent slump is not due to the bursting of a speculative bubble. Opec, the 13-member cartel that produces 40 per cent of the world's oil, has long claimed that the steep rise in price was not justified by "fundamentals'', blaming it squarely on speculators.

But few others believed that. Yes, hedge funds have poured billions of dollars into oil futures contracts, but a recent report by the International Energy Agency concluded that this was largely a result of the price rise, rather than a cause.

Instead, the driving factors are to be found not in the financial markets, but in the real world. It is endlessly reported that the demand for oil in Asian countries has soared since the turn of the century, and that China's thirst has been especially prodigious.

What is less realised is that global oil production has been essentially stagnant, at around 86 million barrels a day, since early 2005.

Despite soaring demand, production outside of Opec has been persistently disappointing, as international oil companies struggle to maintain production from ageing fields. Opec itself has been unwilling - or unable - to raise its output.

So, for the last three years, global oil supply has been a zero-sum game. With supply fixed, and the East consuming ever more, the price had to rise high enough to force the West to consume less.

And that is exactly what happened: overall oil consumption in developed countries has fallen for two years in a row.

The price rise was further fuelled by the fact that consumers in many Asian countries are protected by hefty subsidies. China is estimated to have spent US$40 billion on fuel subsidies in the last year, and Indonesia US$20 billion, so their people could afford to consume more fuel even as the oil price rocketed.

The same is true in Opec countries such as Saudi Arabia, Kuwait and Venezuela, where subsidies keep fuel costs at mere pennies a litre.

But two things have now changed. Saudi Arabia, the only country in Opec with spare production capacity, has finally yielded to international pleas and raised its output, announcing increases of 300,000 barrels per day in June, and a further 200,000 in July.

At the same time, the industrialised world is no longer simply economising on oil, but plunging into outright recession as a result of the credit crunch and the oil price spike - signalling further future cuts in demand.

In the US, the world's biggest oil consumer, motorists are driving fewer miles and deserting gas-guzzling SUVs in droves, leading to a collapse in sales at car-makers such as Ford - which recently announced stunning losses of US$9 billion for the three months to the end of June. In May this year, US demand for fuel dropped to 19.7 million barrels a day - almost a million barrels less than last year.

In Britain, where the price of unleaded has jumped from around 85p a litre 18 months ago to 112p now, drivers are also cutting back.

Yesterday, it was reported that dealers were refusing to accept petrol-thirsty 4x4s in the second-hand market: they cost so much to refuel that they are worth more as scrap.

A recent survey by National Express showed that more than 60 per cent of motorists had cut their annual mileage and were considering greater use of public transport. In Spain, the government has announced a plan to cut oil imports by 10 per cent a year and impose a 50mph speed limit on dual carriageways.

In Asia, too, there are signs of a slowdown. A survey released last week showed that in July, China's manufacturing sector contracted for the first time since 2005.

"China's economic growth has shown a drastic deterioration lately, which is much faster and worse than many people's expectations,'' said Lan Xue, an analyst at Citibank Asia. South Korean oil consumption has been falling for eight months, while Japanese imports have recently fallen for the first time in nine months.

As these countries' budgets come under increasing strain, many are reducing subsidies on fuel - which in turn magnifies the effect of the downturn. In China, the authorities have raised fuel prices by 18 per cent, in Indonesia by almost 30 per cent, and Malaysia by more than 40 per cent.

This ought to reduce future demand, although some analysts warn that in a country like China, where motorists often have to queue for several hours to fill up anyway, it may not make much difference.

Although the oil price may have peaked for now, the impacts of its meteoric rise will continue to be felt. In Britain, prices at the pump should start to fall by the end of the summer, according to the Petrol Retailers Association.

But the impact on energy bills is likely to persist: when British Gas recently raised gas prices by 35 per cent and electricity by 9 per cent, hoisting the average annual bill of its 16 million customers to over £1,300 (a £400 increase), it was a direct consequence of the oil price.

With North Sea gas production in steep decline, Britain is increasingly dependent on imports from Europe, where the price of gas is contractually linked to oil. Since about 40 per cent of Britain's electricity is generated from gas, power prices are also indirectly determined by the price of crude.

As a result, one of the Government's most cherished targets - to abolish fuel poverty among vulnerable households by 2010 - looks unlikely to be achieved.

Instead, campaigners say the number of fuel-poor households - those forced to spend more than 10 per cent of their income on energy bills - will soar to six million by Christmas.

Rising energy prices are not only driving the economy into recession, but also fuelling inflation, which is running at 3.8 per cent, almost double the Bank of England's target.

This creates a major dilemma for policymakers: whether to raise interest rates to curb rising prices, or cut them to stave off the economic downturn. If they get it wrong, there is a danger of both problems becoming entrenched - a return to the stagflation of the Seventies, but even worse.

Amid such gloom, it may be surprising that most analysts continue to predict high oil prices. Barclays Capital forecasts a range of US$115-US$140 a barrel, while Goldman Sachs and CIBC predict US$200 in the next few years. Although the outlook for oil demand might be poor, the prospects for supply could be worse.

"The uncertainty on the supply side is even more than the possibility of softening demand,'' said Shokri Ghanem, head of Libya's Opec delegation.

This is not simply because of political events, such as this week's Kurdish attack on the million-barrel-a-day Baku-Tbilisi-Ceyhan pipeline in Turkey, but because of geological constraints.

Contrary to the sanguine view put forward by Martin Vander Weyer in these pages yesterday, the facts are stark: the world has been discovering less for the last 40 years; for every barrel we discover we consume three; output is in terminal decline in 60 of the 98 oil-producing countries; and hundreds of billions of dollars in investment since the turn of the century have failed to stem declining production at many of the world's biggest oil companies.

As a result, it is widely agreed that oil production in the non-Opec world will "peak'' - reach its maximum possible level - within two years, if it has not already done so. This means that the huge profits being made by multi-nationals such as Shell or ExxonMobil may turn out to be their last hurrah.

"The days of the international oil companies are coming to a glorious end,'' said Fatih Birol, chief economist of the International Energy Agency, last month.

"Their reserves are declining and they will have difficulty accessing new ones.''

Unfortunately, this means that the global oil supply will soon depend on Opec as never before. Many analysts suspect that the Opec countries, which claim to hold three quarters of known reserves, have been exaggerating their size for decades - in other words, they too will soon reach the physical limits of production.

But even if they can raise output, they may have little incentive do so. Creating additional production capacity would cost them billions, for which their reward would presumably be a lower oil price. That might not seem a bargain to them. On the other hand, if they do nothing, the oil price will recover upon any return to economic growth.

Our future seems to hold an unpalatable Hobson's choice: recession or a soaring oil price. Which would you prefer?

-TMI