The escalating price of oil that has surpassed all predictions and projected by some pundits to reach US$200 per barrel threatens a fragile world economy. High oil prices effectively act as a tax on oil importing countries that experience an income shock as their import bill goes up and leads to negative terms of trade. Rising oil prices result in higher inflation and put a brake on production and economic growth. This article tries to explain the reason for the recent “crude” increases in oil prices that has been blamed on a confluence of factors.
Currently, oil accounts for over 8% of world trade and 2.5% of global economic activity and is by far the most important traded commodity. Oil is a finite resource that is non renewable. It should be noted that the recent prices increases are against a background of an unusual rise in most commodity prices in a global economy that is experiencing the longest period of sustained economic growth. Most of the oil produced is used in the transportation sector that accounts for over sixty percent of consumption.
The spike in oil prices now averaging some US$135 per barrel has been influenced by both the demand and supply sides in the market. During the period 2003-2006, oil consumption grew by an average 2.1% per year albeit at a much slower pace in 2007. Most of the increases in oil consumption were fueled by the emerging economies namely China, India and the Middle East. China alone accounted for over 35% of the global increases in oil demand, making China the second largest consumer of oil after the US. The world demand for oil is 86 million barrels per day (mbd) with US, EU and Japan accounting over half of total demand.
Despite increased supply by non OPEC countries, OPEC production has been lower than expected declining by 0.9 million barrels in 2007. Further, the continued political tension in the Gulf States, the US war in Iraq, lower than expected production in Alaska, Mexico and Norway have further aggravated the supply shocks. Global spare capacity has declined from 10 mbd in 1985 to a low 1 mbd in 2005 but climbed to 2.2 mbd in 2007. Oil stocks measured as a proportion of daily consumption in OECD countries is now at a three years low. These factors would have contributed to increases in oil prices that escalated since last year.
Apart from the supply/demand side of the market there is also a body of taught that recent spikes have been influenced by the speculative trading in paper oil in the future and options market.
This resulted in driving the spot prices up to its percent level. Lord Desai pointed out in the Financial Times (05.06.08) that the largest upsurge in oil prices may have been a speculative bubble rather than an outcome of market fundamentals. The US Commodities Future Trading Commission (05.06.08) indicated that there may be a “system risk” while George Soros in a testimony on Capitol Hill earlier this month stated that the Commodity Index Fund which treats oil as an asset rather than a commodity is creating a speculative bubble. However, the role of speculative paper oil in fueling the price spikes was subjected to mixed reactions from US Treasury Secretary, OPEC, policy makers and the media.
The International Energy Agency (IEA) in its monthly oil market report argued that supply growth has been poor in 2008 and higher prices are needed to choke off excess demand to balance the market. IEA has cut its demand forecast in 2008 because of record high prices. The removal of oil subsidies especially in Asia and cutting of demand in industrialized countries especially the US should temper the rising price of oil.
Countries that are oil importers are forced to seriously assess their vulnerability as well as their dependence on oil. Large industrialized countries and now emerging economies are moving in a larger scale towards nuclear power. Nuclear power accounts for over 20% of energy supplies in industrialized countries. Liquefied Natural Gas (LNG) considered the best fossil fuel that generates electricity is another option however; its prices had been moving in tandem with oil. The cost of producing electricity from natural gas is much cheaper and emits only 40 percent of carbon when compared to coal. More recently, the use of ethanol as the new source of clean energy especially for transportation has been gaining momentum.
Higher oil prices have been more devastating on small economies such as Guyana that depends exclusively on oil for both energy supply and transportation. Guyana’s oil imports of US$ 284.6million were equivalent to 42 % of its export earning last year. This means that for every dollar earned 42 cents goes towards oil payments in 2007.
Guyana continues to suffer from the lost opportunity of not having hydropower in place. The Tiger Hill Hydropower project that was financed by a soft loan of US$32 million from the Cuban government was abandoned after Dr. Cheddi Jagan was removed from office in 1964. Repayment of the loan would have entailed the export of surplus rice and wood to Cuba. Dr. Jagan was to later describe the dropping of the Tiger Hill Hydro project by the then PNC/UF (1964-68) collation government as an act of “commission and omission”. Had the Tiger Hill project being in place Guyana would have easily diversified into an industrialized economy given its abundance of raw material. Dr. Jagan on his return to office in late 1992 continued to explore the option of hydro but low oil prices and Guyana’s external debt at that time inhibited the rapid progress on hydro during that period.
Currently, the government is pursing the hydro project potential through a private investor at Amaila Falls. There is also the electricity generation from the baggase at the New Skeldon Factory. The feasibility is being explored for a large ethanol project with a private investor in the Canje Area. In the meantime, the Government has absorbed the increase cost of higher oil prices at the Guyana Power and Light Company in effort to ameliorate the impact on consumer.
In conclusion, the forecast is that oil prices is expected to remain high in the medium term. The high oil prices would have been also influenced by the depreciating US dollar the currency of oil invoice along with the excess liquidity in the market. Even though attempts have made to analyze the high oil prices based on market fundamentals, the current price shocks should also be analyzed within the context of a political crisis that has engulfed the Middle East the peninsular of oil reserves. Hopefully, a favourable outcome to the US elections with a Barack Obama victory should bring an end to the Iraq war and other forms of extremism and provide the framework for overall stability.
