Brian Fallow: Hand to mouth and to pocket

How is this for a straw in the wind: South African mining giant Anglo American has invested $60 million, so far, investigating the possibility of a plant in Victoria's LaTrobe valley to turn lignite into diesel.

The carbon dioxide produced at the plant would be buried in depleted oil fields under Bass Strait.

This company, it would seem, is taking the prospect of a future of high oil prices and constrained greenhouse gas emissions seriously.

A recent analysis of the medium and long-term outlook for oil by the International Monetary Fund paints a picture of a hand-to-mouth oil supply, vulnerable to shocks and increasingly reliant on the Organisation of Petroleum Exporting Countries (Opec).

Even more disconcerting is the view from analysts at investment bank Goldman Sachs who caused some perturbation in the market by suggesting we are staring down the barrel, so to speak, of US$100 ($139) oil, nearly twice its recent level.

The IMF says that over the next five years the high - though gradually decreasing - prices predicted by the futures market will keep oil broadly in balance.

Incremental demand will be met mainly from higher production in non-Opec countries, including Russia.

But the market will walk a tightrope, with little spare capacity to cope with shocks.

"Oil prices will continue to be subject to the risk of large, unexpected price changes."

From 2010 on, it largely depends on Opec, as non-Opec production peaks while global demand continues to rise. If Opec opens the spigot, well and good.

"Most likely, however, there would be growing upside risks to prices," the IMF says.

Just over half of the world's oil demand is from industrialised countries but most of the growth in demand is coming from developing countries.

China and India alone accounted for more than a third of the growth in world demand for oil between 1990 and 2003.

In the short term, demand for oil is pretty inelastic; that is, consumers do not react to high prices at the pump by scaling back their consumption of petrol.

They cut back on other things first. Longer term, prices work.

The oil shocks of the 1970s did have the effect of decoupling economic growth from growth in oil consumption.

On average, oil intensity, or the amount of oil used per unit of economic output, has halved in advanced countries and declined by about a third in developing countries, the IMF says.

On the supply side, it says proven oil reserves are sufficient to meet world demand for more than 40 years.

Allow for improved technology and higher oil prices and the International Energy Agency reckons remaining oil resources could cover 70 years of consumption at the average rate between 2003 and 2030.

So what's the problem?

In two words: concentration and credibility.

Although non-Opec countries produce about 60 per cent of world output, they account for only 30 per cent of reserves. More than half the reserves are in states surrounding the Persian Gulf.

Last week, Saudi Arabia said it was ready to increase its output capacity to 15 million barrels a day, from 11 million now, and sustain that level for 50 years.

But in the absence of independent verification, can we trust state oil companies' estimates of their reserves when a listed company like Shell was able to lie about its reserves for years?

And what if the kingdom of Saudi Arabia were to become the Islamic Republic of Arabia under President Osama bin Laden?

The Goldman Sachs report reminds us that the Middle East has been one of the few areas of the world to experience strong population growth in the past 30 years, in the order of 2 to 3 per cent a year.

"The combination of rising populations, a lack of a diversified economic base and the existence of Governments that are not representative of or responsive to underlying populations, all point to ongoing geopolitical turmoil and an inability to meaningfully add to oil supply."

Key oil exporting countries have yet to take the steps necessary for large increases in investment either by their state-owned oil companies or foreign oil companies.

"Until new investments are made, we believe demand destruction will be needed to recreate a spare capacity cushion in order to return to a period of lower energy prices," Goldman Sachs says.

It believes oil markets may have entered the early stages of what it calls a "super spike" period, a multi-year trading range of US$50 to US$105 a barrel, prices sufficiently high to burn off enough demand to recreate a cushion of spare capacity.

That range corresponds to petrol spending in the United States rising to 3.6 per cent of GDP, 5.3 per cent of consumer spending and 5 per cent of personal disposable income, which is about half as high again as present levels.

Spending on petrol reached higher levels than that in the wake of the oil shocks of the 1970s. If it met those levels again, the top-of-the-range would be US$135 a barrel.

Goldman Sachs does not subscribe to the "peak oil" theory that global oil supply has hit some magical tipping point that will soon result in permanent declines in supply.

Rather, the issue is that a large part of the known resources are effectively off limits to Western investment as a result of host government policies in the Middle East, Russia and Venezuela.

Even if perfect investment conditions existed, it would take five to 10 years to bring major new sources of oil on line.

"The environment looks more like the 1970s than the 1980s or 1990s ... During the 1970s the world experienced an extended period of very high oil prices, stagflation, misery indices [reflecting unemployment and inflation], the fall of the Shah of Iran, an Iranian hostage crisis, the fear that the world was running out of oil, two major Arab oil embargoes and a deep global recession.

"The combination of these events caused a multi-year decline in oil demand which, when combined with continued supply growth, led to an extended period of overcapacity which only recently ended."

The Goldman Sachs report, it has to be said, was derided by petro-pundits. But the moral of the story of the boy who cried wolf is that, in the end, the scoffing villagers were scoffed themselves.

Slippery business

* High oil prices are sapping world economic growth and business confidence at home.
* Some analysts see a return to 1970s conditions and the risk of another doubling of prices to burn off demand.
* The IMF is warning of a tight market, vulnerable to shocks and increasingly reliant on the Gulf states.