Will oil reach $100 a barrel?

published 15 October 2007

Just how expensive is oil? Very. In 2002 a barrel of oil would have set you back only about $20. Earlier this month the price of Brent crude hit just over $80 per barrel, a fourfold increase and, in nominal terms at least, a record. This prompted Goldman Sachs to reiterate their long-term view that the oil price will soon breach the $100 mark and Lord Oxburgh, the former chairman of Shell, to comment that the world is "sleep-walking into a very serious problem" that could, in his view, result in prices reaching $150 per barrel.

Why has the price risen so fast?

Demand is high and rising. In the west, infrastructures are still very oil-dependent (we rely on it for all our transport and heating, for example) and, while there is much talk about how technological advances will mean we soon won't need so much oil, that magic day never seems to come. The US, which accounts for 25% of global consumption, uses 15% more oil than it did in 2000. But the single biggest driver of new demand isn't the west, it's the east. Consumers in India and China's booming economies are demanding more cars, air travel and electrical appliances, all of which use oil.

There may be no more to drill for. The International Energy Agency predicts that the global production of oil will peak as early as 2012, a view shared by the London-based Oil Depletion Analysis Centre whose head, Dr Colin Campbell, likens the problem to one "any beer drinker will understand the glass starts full and ends empty and the faster you drink it the quicker it's gone". Specifically, the IEA forecasts that, although global demand will grow by 2.2% over the next five years, supply growth will be limited to just 1%. Its stark conclusion is that the world will be running down existing reserves within a matter of a few years, raising the prospect that we will run out of oil much faster than many realise.

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Opec a cartel which represents the oil-producing countries and controls around 40% of global oil production plus 75% of all reserves has been able to push up supply and alleviate oil price rises by increasing production or reducing stocks. Opec does, after all, have a vested interest in keeping the price down at a level where consumers continue to use "black gold" rather than switching to alternatives. However, not everyone is convinced that it can keep repeating this trick. Liam Halligan in The Daily Telegraph cites its "desperate" search for new oil fields and notes that, although the cartel operated the highest number of rigs last year since 1980, in terms of tapping any significant new fields it has "for the most part drawn a blank".

This matters: in the ten years from 1985 to 1995 analysts estimate that reserves grew by 3% per year, but last year they fell by 0.55%. High oil prices already mean that more effort is being put into tapping some of the world's trickier oil and gas deposits, such as those sitting under Canada's tar sands, in Venezuela or even within the Arctic circle, but doing so is both difficult in technical terms and very expensive. The basic truth is that the world's oil, and in particular the world's cheap oil, is running out: we need alternatives.

There are actually plenty of alternatives to oil already, but most are either not economically viable or environmentally acceptable. There is plenty of coal and natural gas around. However, not only are both "dirty" fuels, but gas is expensive to extract and transport. Hydrogen fuel cells also sort of work, but while they may be green, they can't even begin yet to create energy on the scale or at the price we need. Next up is ethanol. Many see this as a viable alternative to oil, but it just isn't: growing its ingredients takes up too much land (something that is already fuelling food inflation), and there is some doubt over whether it can ever be really cost-effective. Finally, there are solar and wind farms, neither of which offer a complete solution, and of course nuclear power. The latter could be a solution were it not for the controversy surrounding it. This means that plants can't be built often enough or fast enough to even begin to make up for the supply crunch in the oil markets.

Inflation. Fast-growing emerging markets like China, where one-year lending rates are already at a nine-year high, are struggling to control price rises driven by increasing commodity costs. Meanwhile, slowing economies such as ours face the prospect of stagflation; a nasty combination of rising prices coupled with declining GDP growth. The last oil price shock back in the 1970s brought recession with it. We should hope history doesn't repeat itself.

We are long-term fans of the big oil companies, BP (BP) and Shell (RSDB). With share prices for FTSE 100 companies down this summer following fallout from the credit crunch, now is a great time to pick up both at a decent price. BP trades on a p/e of just over 12 and offers a yield of 3.5%, while Shell is available on a p/e of just 10.5 and offers a yield of 3.4%. Interest-rate reductions on this side of the Atlantic, now more likely in light of the Fed's latest move, would provide an extra stimulus to both.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.