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THE BUSINESS: FOCUS: OIL PRICES: $50: Is this the final frontier for Oil?: The margin between supply and consumption of oil is wafer thin. There has always been little room for error… there is even less now: “oil companies are scouring the globe in a desperate quest for new fields. Without major finds, the price of oil will surge further, damaging the global economy and share prices” (


By Richard Orange


and Allister Heath



The acrid, unmistakeable stench of petroleum is the first thing that hits the weary traveller landing at the cavernous airport of Baku, the capital of Azerbaijan. The smell is everywhere, for this is the front line in the race by the world's oil super-giants to find more reserves and meet the ever-increasing thirst for oil.


It is in out-of-the-way places like Azerbaijan that BP, ExxonMobil and Total are spending billions of dollars upgrading Soviet-era machinery in the hope of adding millions of barrels a day to world petroleum output. As oil prices breached the symbolic $50 a barrel level in New York last week, the fate of the world's economies is increasingly dependent on them succeeding. It is a daunting task.


The barren landscape to the east of Baku is crammed with thousands of crumbling, rusted iron derricks and creaking nodding-donkey oil pumps, extending in all directions. There are more derricks offshore, in the shallow waters of the Caspian; some even extend into the city itself.


The result of decades of leaking pipework and faulty pumps trickles down in black rivers to form great pools of oil, covering most of the land between the raised access roads, and leaving an inky film along the Caspian coast.

But amid this scene of environmental devastation, two huge, ultra-modern construction sites are transforming^ the landscape.


Thousands of workers swarm over the immense developments BP has carved out of the desolation of the old Baku oil fields. The firm is building six oil platforms on a conveyor-belt system to help develop Azerbaijan's offshore reserves, originally discovered by the Soviet Union.


The Asberon peninsular on which Baku lies was the site of the mysterious ancient "eternal pillars of fire" worshipped by Zoroastrians - caused by natural gas. In the 13th century, Marco Polo described the oil springs of Baku as a wonder.


But in the 21st century, Azerbaijan is host to the world's largest integrated energy project, a $20bn (€16.3bn, fll.lbn) development that will over the next two years, BP says, provide a quarter of the world's new oil supply. If this materialises, it will be good news: the market hasn't had such hunger for new oil since the crisis of the 1970s.  


WHEN oil breached the $50 a barrel-level last week, the rise was blamed on worries about rebel threats to Nigeria's main oil producing region. But the spike in prices could equally have been caused by an oil workers' strike in Venezuela; or Norway; or a bomb blast in Saudi Arabia; or more worries about Russia's oil giant, Yukos; the security situation in Iraq; or a fierce hurricane in the Gulf of Mexico - or a combination of all these.


The truth is that the world's oil supplies have always been at risk from something somewhere. In Nigeria, a notorious trouble spot, violence cut oil companies' production 20 times between 1997 and 1999. There have always been hurricanes in the Caribbean, as there have been wildcat strikes in the oil industry.


What has really been pushing up the oil price is the wafer-thin margin between supply and consumption, thanks to a surge in demand led by developing countries. There has always been little room for error; there is even less now.

The unexpected surge in Chinese growth has cut the world's spare pumping capacity to just 1m barrels per day (bpd), about 1% of demand, well short of the 4% needed to ensure a sufficient buffer against supply disruptions.


Charles Dumas, an economist at London-based Lombard Street Research, said: "Of the world's oil demand of a little over 80m bpd (barrels per day), more than 30m bpd now represents the developing world." Demand from the developing world is growing at about 5% a year. By contrast, oil demand from Organisation for Economic Co-operation & Development (OECD) countries is growing at 1.25%, or 0.6m bpd.


The combined extra demand, of 2.1m to 2.2m bpd, means that the world's thirst for oil is growing at between 2.25% and 2.75% a year, faster than in the 15 years from the mid-1980s oil price collapse until the early 2000s.


"The growing weight of Asia means this could accelerate further in the medium term. Supply growth will only match this acceleration of demand at higher prices that are believed by producers and the stock market to be durable," said Lombard's Dumas.


Not only is Asia in large part responsible for the surge in demand, it will be most affected by the higher prices.

Despite many economists rashly dismissing the damage the surge in oil prices will wreak on the global economy (a mistake not made by this newspaper), the effects of the recent hike are already starting to be felt, as the slowdown in world growth demonstrates.


The International Monetary Fund (IMF) said last week that "crude oil prices remain a key determinant of global economic prospects. Higher prices affect the global economy through a variety of channels." Partly as a result, it cut its global gross domestic product (GDP) growth forecast to 4.3% for next year, against 5% for 2004.


The biggest impact on the economy will come from a much higher cost of production for both goods and services, hitting profit margins and spilling over to the financial markets in the form of lower share prices.


In the case of the rich countries, this supply-side shock, very significant in the 1970s, will be less pronounced this time, pardy because western countries have reduced their dependence on oil, partly because prices in real terms remain lower than their all-time inflation-adjusted high of $80 or so a barrel. By contrast, developing countries will be hit harder because they rely more on oil.


Nevertheless, according to the IMF, every $5 increase in oil prices reduces global growth by about 0.3 percentage points after a year. With prices set to stabilise around $15 higher than expected two years ago, this means global growth will be almost one percentage point lower than it would have been. By contrast, the 1978-1980 oil shock is estimated to have slashed world GDP by 3.7 percentage points.


But, while the current problems are undoubtedly not as severe, they will affect jobs, company profits, pay rises and asset prices.


The hit to growth will be slightly higher in poor countries and smaller in rich countries. The UK is unlikely to be affected overall. Though consumers and most companies will lose from higher costs, North Sea oil producers and the UK government will gain higher revenues. Russia and Norway will also benefit, as will members of Opec.


But every $5 rise in oil cuts GDP by 0.4 points after one year in the United States and the euro zone; and by 0.4 points in China and 0.5 points in India; in the case of China and India many economists believe the effect will be even stronger.


Peter Morgan, a Tokyo-based economist at HSBC, last week doubled his estimate of the direct cost to the Japanese economy of the surge in oil prices. Its cumulative direct impact on growth will now reach 0.6 percentage points, he says; even that neglects the indirect impact of higher oil prices on growth in other countries, which would then hit Japanese exports.


Morgan said: "We estimated the combined effects on Japanese GDP of the direct impacts of oil at $50 a barrel on domestic demand, the impact on Japanese exports from weaker growth overseas, and the indirect impact of weaker exports on domestic demand. We find that this roughly triples the overall impact, to about 1.5 points of GDP over three years."


The supply-side impact of the new oil shock will not be limited solely to lower growth. It could also trigger higher consumer price inflation: companies may try to pass on the cost of higher input prices to customers, a move which would be followed by increased demands for wage rises.


In practice, the effect of the current oil shock on inflation is likely to be limited, because companies have less pricing power and central banks show no signs of wanting to loosen monetary policy to help companies cope with higher oil prices.


Global demand will also suffer from higher oil prices, which acts as a tax on oil consumers and a handout to oil producers, transferring income to Opec countries.


Eric Chaney, economist at Morgan Stanley, in response to the rise in crude prices, says "companies will squeeze profit margins to keep volumes steady and, being less profitable, cut down investment plans. Seeing their purchasing power dented, consumers will either draw on their savings to maintain their living standards or spend less."


Chaney argues that consumers could at first finance extra energy bills out of their savings but only if they were convinced that the rise were temporary. But unlike the spike caused by the Gulf war, which was obviously attributable to one event, it is hard to identify the causes of the current surge - which means that consumers are likely to cut back their spending far sooner.


In addition, higher oil prices are already having a damaging psychological impact, hitting consumer and producer confidence and affecting consumer spending and company investment. As the IMF puts it in its study, the knock-on effects "in terms of investor confidence and willingness to commit to longer-term capital projects may lower growth prospects further".


ANOTHER crucial factor in the delicate supply/demand equation is that there have been some miscalculations on the part of the oil companies that have led to the lack of supply and triggered the current surge in oil prices. A vicious boom-bust investment cycle has also played its part in the current shortfall. You don't have to go far back to find the reason.


The industry spent the 1990s in retrenchment after the investment boom that followed the 1973 oil crisis left it with over-capacity of 10.7m bpd in 1985. The ensuing oil price crash meant executives focused on cost-cutting, while companies grew through mergers and acquisitions rather than exploration.


Much of the over-capacity of the 1980s, concentrated in the North Sea and Alaska, is now drying up, and the new areas being opened up, particularly in the deep waters of the Gulf of Mexico, West Africa and the Caspian, will

struggle to meet the world's supply needs.


Exxon Mobil chief executive Lee Raymond said at last month's Opec conference that the world would need to bring on a staggering 65m to 85m bpd of new capacity by 2020 to meet demand - more than double today's output.


So far the industry has been slow to direct windfalls from the past few years' high oil prices into new projects and exploration, preferring to reward shareholders by buying back shares. This was in the belief that the current spike would be short-lived, a mistaken assumption shared by the majority of energy analysts until the past few months.


The International Energy Agency (IEA) has also been slow off the mark. It only seriously started to call for increased investment from companies and producing countries last April, arguing that spending levels were 15% short of the $210bn it estimated would be needed every year to meet demand.


In the short term, though, the IEA thinks there are enough mega-projects to to keep the oil price rise in check. "We do have fairly buoyant non-Opec supply growth over the next few years," says IEA supply analyst Klaus Rehaag. "I think that's something the markets are overlooking."


He estimates that around 1.3m bpd of net new non-Opec supply will enter the market next year, around half of which will come from former members of the Soviet Union, with most of the balance coming from West Africa, Brazil and the Gulf of Mexico. After that he expects around 1m bpd in net additions until 2008, with the Caspian by then playing a key role.


By the time BP's Azerbaijan licence •expires in 2022 the amount of oil and gas the project will have brought to global markets from the country will dwarf its historic production.


But by then, oil demand could still be soaring as China continues its transformation from an emerging economy to a fully-fledged developed country. For the oil companies, it will be time to move on - and to scout across the world for new oil fields.

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