by Scott B. MacDonald
YORK -- Oil
prices are high and likely to climb higher through 2005
and probably into 2006. Despite ongoing comments about
the market actually having enough supplies, the reality
is that international oil markets are not driven by anything
rational. Rather fear and loathing sit at the back of
each upward oil trade. A confluence of increased demand
and questionable limits to supply have resulted in a
runaway oil market during the summer of 2005, with oil
heading to over $65 a barrel. The idea of oil hitting
$75 a barrel is no longer so far-fetched. All of this
has implications for the global economy and world stock
High Oil Prices – Why?
High oil prices are likely to be around for a while.
On the supply side, the nagging points of concerns include
the expectation that non-OPEC oil supply, mainly in the
Gulf of Mexico and the North Sea are set to fall. According
to the International Energy Agency (IEA) in August, non-OPEC
oil supplies are forecast to fall 200,000 barrels a day.
Part of the reason for this is that political factors
and less attractive investment regimes are hurting the
discovery and development of new oil sources in countries
such as Mexico and Russia. This puts much more pressure
on Middle Eastern oil producers, in particular Saudi
Arabia. Yet, there is concern about the true level of
Saudi Arabia’s oil reserves. Considering that there
is a debate over the quality of transparency and disclosure
of Saudi reporting, this only adds another factor of
Adding to the stew over oil prices, is the nature of
global refinery capacity utilization. During the early
and mid-1980s, global refinery capacity utilization was
around 75 percent; today it has risen to above 95 percent.
U.S. refineries have especially seen heavy use, with
capacity utilization reaching a little over 98 percent.
Considering that the refinery sector was long a problematic
area for oil companies to make money, the sector is largely
defined by underinvestment and aging equipment. In addition,
there has not been any new construction of refineries
for environmental reasons since the 1980s. This set of
conditions has meant that existing refineries are under
stress, breaking down or stopping operations to make
repairs. Since July 20, 2005 there have been 14 refinery
The U.S. refinery system is being pushed beyond its sustainable
limits. As Richard Savage, global head of commodities
research at Bank of America recently stated: “There
are clearly issues in both production and refining capacity
because plants have been running so hard that accidents
Add to the above factors, damaging hurricane seasons
in the Gulf of Mexico and the added weight of Chinese
and growing Indian oil demand, not to mention the threat
of geo-political factors, and a bet on higher oil prices
does not seem unreasonable. At the same time, the global
economy has not taken a major nosedive. In the past,
oil prices spikes have resulted in economic downturns
or recessions. Thus far, we have strong economic growth
despite higher oil prices, largely due to lower energy
Indeed, the International Monetary Fund
is projecting 3.6 percent growth for the U.S. in 2005
and again in 2006, with increased economic growth in
both Japan and Euroland.
As a result, demand for oil is not likely to relent.
That makes oil the key swing factor in the global economy
over the next couple of years. Although we still have
questions about oil breaching the $100 a barrel mark,
the general nervousness in the market, the ability of
hedge funds to push prices up, and the existence of many
geo-political wildcards all translate into upward pressure.
The new world of higher oil prices has considerable implications
for the structure of international relations. It has
already added a degree of tension between the United
States and China over the Chinese state-owned oil company
CNOOC seeking to purchase U.S.-owned Unocal. It has generated
new tensions between China and Japan over potential oil
and gas reserves in the seas between them and over access
to Russia’s energy sources. Competition for oil
and gas has also stimulated a return of big power interest
in Africa and a new scramble for that continent’s
resources, allowed Venezuela’s populist leader
President Hugo Chavez to pursue an anti-U.S. foreign
policy in the Americas which includes generous oil aid
to Cuba, and provided an opportunity for China to develop
closer ties with a number of Latin American countries.
The New Flow of Funds
Venezuela’s Chavez enjoys theater. Seeking to bait
the United States, he has steadily announced that Washington
plans on invading Venezuela. He is also making use of
higher oil prices to consolidate his position internally
as well as providing help for other leftist leaders and
organizations throughout Latin America. In 2002, Venezuela’s
foreign exchange reserves stood a little over $8 billion;
as of mid-2005 they stand around $20 billion. Having
eroded the control of the central bank over the country’s
foreign exchange reserves, Chavez can benefit from the
rise in reserves by increasing social spending and offering
to buy back debt to help Ecuador and Argentina. The former
is also likely to help Chavez win re-election in 2006
for another six years.
Hugo Chavez is not alone in benefiting from the oil boom.
The Gulf States, including Saudi Arabia, Kuwait, Bahrain,
Qatar, and United Arab Emirates are currently pumping
oil at the highest rate in 25 years to keep pace with
growing demand. Throughout the region this trend is evident
in faster growth rates, improved fiscal positions and
rising foreign exchange reserves. According to the Washington-based
Institute of International Finance: “Gulf State
countries will buy about $360 billion in foreign assets
from bonds to property in 2005 and 2006 – 50 percent
more than their total purchases of the past 5 years.” A
lot of this money is heading into U.S. and European markets,
but also into the rest of the Middle East.
The Geo-Political Factor as a Trump Card
Although the antics of Chavez make colorful copy, the
major geo-political concerns are largely centered on
the Middle East. This is because three of the world’s
four largest oil reserves are located in the Middle East – Saudi
Arabia, Iran and Iraq. Each of these have problems. Iraq
remains locked in a civil war, with its oil industry
a target of sabotage. Its level of production is well
below its potential.
At the same time, neighboring Iran has just elected a
hardline government under President Mahmoud Ahmandinejad.
One of the cornerstones of the new government is the
pursuit of nuclear power. Despite negotiations to prevent
the emergence of a nuclear Iran, Teheran is determined
to join the ranks of the nuclear powers. This is especially
the case now that North Korea, India and Pakistan already
have nuclear weapons. Iran’s policy, therefore,
is set to put it on a collision course with the international
community, which could encompass United Nations sanctions.
Saudi Arabia, the world’s leading oil country,
also faces major political challenges going forward.
The Middle Eastern country is a closed society, confronted
by difficult problems of extremist Islamic fundamentalism
and increasing demands for economic and political reform.
And then there is the issue of political succession.
On August 3, 2005, the Saudi religious and tribal leaders
gathered in Riyadh to pledge allegiance to new King Abdullah
bin Abdel-Aziz al Saud, following the death of his half-brother
King Fahd. Considering the smoothness of the succession,
it appears that the Saudi royal family is well entrenched
in power. The network of family relations, firm control
over the state security apparatus and ability to tap
the country’s oil wealth give the appearance of
control and stability.
The reality of the Saudi situation is that it is a restless
society, with a young, relatively well-educated and generally
underemployed population. Caught between influences from
the West via satellite TV and a strict Wahhabist Islamic
code, Saudi society has become more volatile, and the
future path less certain.
Looming over the political landscape remains the political
succession. Saudi Arabia’s new King Abdullah has
been the real ruler of the country since 1995 when King
Faud suffered a debilitating stroke. While this means
continuity in policies, Abdullah is already 82 years
of age. This means that political succession sits out
on the horizon, probably sometime in the next 10 years.
The problem of an aging leadership elite is compounded
by the fact that the next three leaders in line of succession
are likely to be Crown Prince Sultan, a spry 81 years,
Interior Minister Prince Layef, 71 and Riyadh Govenror
Prince Salman, 70. As Stratfor observed: “Even
if succession takes place in this sequence, transitions
will take place much more frequently than before, rendering
the system progressively less and less stable.”
Oil markets are likely to remain volatile going forward,
with more pressure for prices increases than declines.
The global economy has thus far been able to absorb the
price increases due to past improvements of technology,
which augmented energy efficiency. However, sitting somewhere
out on the horizon is a point where oil prices are too
high and disruptive to economic activity.