No recovery for oil

After bottoming close to $37 per barrel in mid-February, oil rose some 50 percent and now trades at $52 per barrel. Officials in Venezuela, Russia's new ally and another major oil producer, believe oil prices can bounce back to $90 per barrel by the end of the year.

True, the International Energy Agency has just cut its forecast for oil demand, and China reported a 5.5 percent drop in crude imports. But this makes long-term prospects even brighter. Cambridge Energy Research Associates warned low oil prices and a global credit crunch could reduce investment and create an oil shortage by the middle of the next decade. Merrill Lynch envisions this happening even sooner, by 2010 or 2011.

Although at first glance it would seem demand for oil is generally stable, prices are notoriously hard to predict. Nevertheless, no one had anticipated a precipitous plunge in oil prices in the fourth quarter of last year. Instead, in mid-2008, with the global recession already underway, most analysts warned that oil was headed for $200 per barrel.

In order to glean the future of oil prices, it is important to understand what has happened in recent years-namely, why oil prices went from less than $10 per barrel to $147 over the past decade without creating a major recession.

There were many reasons, but what was key was that the world economy enjoyed extremely robust growth. It is known that labor productivity increases in recoveries and declines in recessions. When orders increase, employers first get more out of existing workers before hiring new ones.

The same is true of all other industries, including oil. It is easy to see why using simple examples. Trains and buses, for instance, carry more commuters, each of which produces more output. Or, when a trucking company has a full order book, its trucks are loaded to capacity, each earning more money per run. When orders decline, trucks travel half full, producing less gross domestic product per gallon. From 2003-2008, oil output grew on average by 1.8 percent per year, while the real gross world product expanded almost twice as fast, by 3.4 percent. In other words, it took progressively less oil to produce a dollar of output.

Even if the current global slump comes to an end by early 2010, growth will remain sluggish and fragile. Demand will remain weak everywhere, and the global economy will not be able to absorb renewed oil price increases. A similar situation occurred in 1979. When the Iranian revolution pushed up oil prices, the global economy was already stagnating. Oil became the last straw that plunged the world into a deep recession, accompanied by defaults from international debtors.

The same is likely to happen this time. Even if oil supplies do not expand in the coming years, OPEC and other oil producers will find it difficult to raise prices. Of course, oil prices may still spike because of a sudden political jolt or military conflict. But higher oil prices will then trigger a contraction in global economic activity and a renewed price decline. It should be remembered that in the early 1980s, the recession ushered in a long period of declining oil prices, culminating in $10 per barrel by the end of the 1990s.

Alexei Bayer is an economist based in New York.

First published in The Moscow Times

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