Demand puts price of oil over a barrel

CHARLIE FELL SERIOUS MONEYBLACK GOLD is back centre stage. The protracted bull market gathered momentum in recent sessions, with the price of a barrel of oil climbing to an all-time high of almost $120, a more than 80 per cent increase year-on-year.

The oil price has climbed more than $30 since the most recent lows in January, despite a US recession and an impending economic slowdown across the developed world.

Numerous reasons have been put forward for the recent increases, including weakness in the dollar (the currency of oil); attacks by the Movement for the Emancipation of the Niger Delta (Mend) on pipelines in the oil-producing region; increased tensions between the US and Iran in the Strait of Hormuz; a strike at Scotland's Grangemouth refinery; and, of course, the usual suspect investor speculation.

However, an examination of the fundamentals suggests that supply/demand tightness is likely to persist and, consequently, the price of oil should remain elevated.

Demand has slowed in the developed world in the face of slowing economic momentum, high prices and the growing efforts to limit greenhouse gas emissions.

Indeed, oil consumption in the developed world dropped in 2006 and 2007 for the first time since the early 1980s and demand will almost certainly weaken once again this year. However, sluggish demand in the developed world has been more than offset by robust increases in consumption elsewhere.

Demand growth has reached almost 4 per cent a year in the developing world in recent years and global supply has struggled to keep pace. Should current trends persist, developing economies will become the major consumers of oil within a decade.

Much has been written about the rise of China and India and their seemingly insatiable appetite for oil. Together, the two countries accounted for almost 40 per cent of the increase in global demand since 2004 - China (33 per cent) and India (6.5 per cent).

The importance of the oil-producing countries themselves in the demand equation has not been well documented, even though they have become an increasingly influential determinant of world prices.

The Persian Gulf economies are enjoying a sustained period of relative prosperity, not only as a result of higher oil prices, but also from concerted efforts to diversify their economies beyond energy to provide employment for rapidly growing populations.

The greater oil intensity of the region's economies has contributed to rising demand on the back of robust growth, as too has the emergence of a new middle class, which has not been deterred by higher prices due to the provision of generous state subsidies.

In Saudi Arabia, for example, retail gasoline prices are just $0.50 a gallon, compared with $3.60 in the US and almost $8 in Germany and Britain.

The heavily-subsidised price results in a somewhat paradoxical situation whereby demand in the Persian Gulf rises in the face of higher prices, as the boost to incomes leads to increased consumption of subsidised gasoline.

Indeed, oil consumption has been growing three to four times faster than global demand over the past five years and is commanding an increasing share of incremental demand - more than one-quarter over the past two years.

Russia has also benefited greatly from soaring energy prices in recent years - hardly surprising given that it is the world's largest oil producer. The Russian economy is firing on all cylinders and growth reached 8 per cent in 2007.

Private consumption has responded to the buoyant economy and car sales have been growing at double-digit rates. Demand for air travel is also increasing rapidly. The end result is that Russia has accounted for 6 per cent of the increase in global oil demand since 2005.

The acceleration in domestic oil consumption in both the Persian Gulf and Russia has arrived just as their ability to meet growing demand elsewhere is deteriorating.

Both Kuwait and Saudi Arabia have struggled to raise production in recent years and strong internal demand calls their ability to boost future export capacity into question.

Russia, which had gravitated to the position of swing producer in recent years, saw first-quarter supply drop year-on-year for the first time this decade and the outlook is not encouraging. A heavy tax burden at 80 per cent of all profits above $27 a barrel combined with market-unfriendly government policies and infrastructural constraints have discouraged investment and supply is now price inelastic.

The recent surge in oil prices appears to defy economic logic, given the demand destruction in the developed world, causing many to cite investor speculation as the primary cause.

However, the economic fundamentals in the oil-producing countries themselves, which have gone largely unnoticed, appear to justify the continuing bull market.

Strong internal demand among oil producers, aided by price subsidies in the Persian Gulf and combined with an inadequate supply response that is hampered by government policy in Russia, means that oil producers are less able to meet the needs of the rest of the world. High prices are here to stay.

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