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Why oil prices will rise even higher

ALASTAIR SHARP

Saturday, July 05, 2008

LONDON — Oil's meteoric rise since the start of the year to nearly $150 (U.S.) has distressed consumers and policy makers the world over, but the stark reality is prices are likely to rise higher still.

For two decades, prices were relatively stable, but then they rose seven-fold from a trough below $20 in 2001. Since breaching the $100 mark on the first trading day of this year they have risen around 45 per cent.

Given such momentum, politicians' efforts to bring the price down could well be a waste of energy.

“It rose so fast it's got a bubble feel, but bubbles can go on for very sustained periods, and underlying that is an extremely tight fundamental position,” said Stephen Thornber, head of global energy research at Threadneedle Asset Management.

Global demand of some 86 million barrels per day is almost level with supply, and production growth is not keeping pace with soaring demand from emerging economies such as India and China.

Citing the strength of Asian demand, investment bank Morgan Stanley last month predicted oil would reach $150 a barrel by Friday's Fourth of July holiday in the United States, usually one of the busiest U.S. travel days.

Their target proved just out of reach, with U.S. crude stopping short at a record of $145.85.

But the bulls have not gone away. Goldman Sachs, the biggest investment bank in the commodities sector, has tipped prices to hit $200 a barrel within two years.

Already prices are undoubtedly causing pain as protests at rising costs have broken out across the world.

Consumers, particularly in the world's biggest energy burner the United States, have begun to cut back on fuel use, but there is no ready substitute when it comes to transportation.

“You have to go to work, no matter what the price is,” said Mr. Thornber. “Fundamental demand for transport and energy is difficult to turn off in the short term, but disposable income will be hit.”

A sustained period of growth across the world was largely reliant on cheap energy and policy makers are fearful the unprecedented rally on the oil market will undo that.

“The longer it stays at this level or the higher it goes, the more pain it is going to cause in lots of different industries,” said Colin Morton at Rensburg Fund Management.

Even oil companies say their gains have been muted.

“People think that at $140 we make fortunes,” Repsol CEO Antonio Brufau told Reuters this week. “We pay fortunes in taxes, that's true, but the countries that benefit the most are the ones that own the reserves.”

For their part, the Gulf exporters – which provide almost a quarter of the world's oil – are suffering rampant inflation, as their U.S. dollar-pegged currencies import higher prices.

The dollar's weakness relative to other currencies has been partly responsible for the rise in oil and other dollar-denominated commodities as investors try to hedge against inflation and take shelter from battered stock markets.

For central bankers, oil is a vexed problem. It has exacerbated a slowdown in economic growth and stoked inflation.

The natural remedy for inflation should be higher interest rates, but the fear is that could add to the problem of slower growth.

“It (record oil) is constraining what policy makers can do, said Richard Batty, global strategist at Standard Life Investments.

While there are no easy policy answers, expensive oil and weaker economic performance could eventually dent fuel demand enough to lower prices.

“The oil price is not necessarily reflecting the fundamental backdrop at the moment and eventually it will have to as the fundamental backdrop continues to weaken,” Mr. Batty said.

The more bullish analysts argue that even if developed countries change their habits, emerging economies will continue to drive up demand and oil prices, which are arguably still too cheap.

The Organization of Petroleum Exporting Countries has conceded prices at current levels are expensive in relative terms, but the group's secretary general has also pointed out that per litre crude is cheaper than bottled mineral water.

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