The Trouble With Gushing Oil Demand

Traders, worried about any interruption in supply, have bid up prices

One year ago, when coalition forces were rolling to victory in Iraq and optimism abounded, crude oil for delivery in May, 2004, was running at $25 a barrel. Today, the New York Mercantile Exchange price for oil delivered next month is over $36 -- a nearly 50% increase in the futures price for one of the industrial world's most essential commodities. Costly oil has helped drive up the U.S. retail price of regular gasoline to a record national average of $1.79 a gallon, a 20% hike so far this year. Now for the really bad news: While the price of oil could retreat in coming months, hopes for a quick return to $25 a barrel are increasingly remote.

The main problem: Worldwide demand for oil is growing fast, led by China and the U.S. At the same time, the amount of spare production capacity worldwide is down to a little over 2 million barrels a day. That's just half the wiggle room that existed in late 2002, according to Energy Dept. data. So even though oil supplies seem adequate today and more projects are coming online soon, the markets are on edge. Traders have bid up prices out of concern that there won't be enough oil available if demand exceeds expectations. They're also pushing up prices because, in the volatile world of oil production, there's always a chance for a big interruption in supply.


The only good news in this picture: So far, fears that high oil prices would depress economic growth haven't come true. The most recent leap in the volatile oil market occurred on Apr. 9, after the International Energy Agency revised its world oil-demand forecast upward for the sixth straight month. The agency estimated that China's oil demand rose by 18% in the first quarter -- and is likely to grow 13% for the year as a whole. While much of that reflects industrial growth, China's rapidly expanding consumer class is also pouring money into new cars. "China's economy just keeps rolling, and there is no imminent sign that it's going to stop," Klaus Rehaag, head of the IEA's oil industry and market unit, told reporters. The IEA expects world oil demand to grow over 2% this year, with China alone accounting for 40% of the jump and the U.S. -- the world's biggest energy user -- for close to 20%.

With demand so robust, it's easy for the market to get spooked by fears of supply shortfalls. For one thing, traders are worried that OPEC is pumping too little oil, which could cause prices to spike even higher later this year. Led by Saudi Arabia, OPEC cut official production quotas by 1 million barrels a day as of Apr. 1, although actual production is unlikely to fall much because of quota cheating. OPEC says that by holding the line on production, it's just trying to avoid a glut. Some members argue that the high price of oil is necessary to offset the slip of the dollar against the euro and the yen. Since oil is paid for in dollars, the currency's decline has reduced the buying power that OPEC gets in exchange for its oil.

Worries over unrest in Iraq and fears of more terrorist attacks, especially on oil facilities, are also rattling markets. If Iraq were to descend into chaos, the 2 million barrels a day it's now producing could quickly drop to nothing. An even bigger concern is instability in Saudi Arabia. Sporadic violence continued on Apr. 13, when militants killed four Saudi policemen and escaped in their cars. One nightmare scenario: al Qaeda launching large-scale attacks on Saudi Arabia's oil infrastructure, such as Ras Tanura, the artificial island in the Persian Gulf that is the world's biggest facility for loading tankers with crude. "You could crash a plane into that and take 3 to 4 million barrels off the market overnight," says Gal Luft, executive director of the Washington-based Institute for the Analysis of Global Security.


Of course, if the world can dodge terrorism and political turmoil, the outlook for oil prices is far more sanguine. There's plenty of oil in the ground that's recoverable at low cost. Indeed, oil companies are revving up projects in promising new fields from the Caspian Sea to the deep waters off the coast of Angola. If producers follow through with their plans, then by 2008, says IHS Energy, an Englewood (Colo.) consulting firm, these projects could boost world oil output by 12%, or nearly 10 million barrels a day. That's a lot. By contrast, the Energy Dept. estimates that it will take until 2010 for world consumption to rise by 9 million barrels a day -- meaning that an oil glut could materialize in the medium term. "There's a pretty good chance that we'll see prices decline," says Philip H. Stark, IHS Energy's vice-president for industry relations.

That rosy scenario again depends on global stability. Politics could easily disrupt some projects. Russia accounts for fully 17% of the total projected world production increase by 2008, according to IHS. But that won't happen if Russian oil companies run afoul of strongman President Vladimir V. Putin, who recently jailed Russia's richest oil magnate, Mikhail Khodorkovsky.

Elsewhere, ethnic unrest continues to threaten Nigeria and Angola, which IHS projects will have the biggest output increases in Africa. In Kazakhstan, the new oil star of Central Asia, the fear is Islamic terrorism, which has already begun to take a toll on neighboring Uzbekistan. Venezuela remains embroiled in a power struggle between President Hugo Chávez and the nation's middle class, including white-collar oil workers. So even though there's no shortage of oil in the ground, there's still reason to worry that we'll be paying high prices for crude and gasoline for a long time to come.

By Peter Coy in New York, with Stanley Reed in London and Jason Bush in Moscow

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