Amid all the economic optimism for 1997 emanating from September's gathering of finance ministers in Washington, there was only one serious cloud on the horizon: the recent rise in crude oil prices. In the third quarter of this year benchmark Brent crude oil traded at an average of $20.71 per barrel, up 28 per cent from a year ago. While this is far short of the $40 a barrel levels seen during the buildup to the Gulf war six years ago, the sharp rise in energy prices is already adding significantly to airlines' costs.

Brent crude bottomed out at $13.90 a barrel in the first quarter of 1994 and rose to $16 on average last year, reaching $17.20 at the end of 1995. This year has seen a surge in prices, which have been driven up by supply shortfalls, low stocks, strong demand from the fast growing economies of the Pacific basin, and, most significantly, the political struggle with Iraq.

In June Iraq reached an agreement with the United Nations under which it would be entitled to export 600,000 barrels of oil a day, with the proceeds being used for humanitarian purposes. This extra supply would have been enough to suppress oil prices, or at least hold them stable, for a few months.

However, this was followed by Saddam Hussein's thrust against the Kurds, the temporary suspension of the UN deal, and the buildup of western military forces in Kuwait and the Gulf. These developments raised the spectre of a new Washington-led conflict and resulted in the sharp runup in oil prices in the third quarter.

A prolonged period of higher oil prices will clearly have important implications. In broad economic terms higher oil/commodity prices feed into the inflation pipeline and can either be accommodated by allowing inflation to rise, or combated through higher interest rates. Either way the result would eventually be slower economic growth.

For big users of oil, the impact of higher prices is felt almost immediately unless buyers are large enough or smart enough to have hedged their contracts. Of course, the oil exporting countries and the major oil companies see an immediate benefit.

No wonder everyone is asking how long the current surge in oil prices will last. A new study by the International Monetary Fund suggests that, barring new hostilities in the Middle East, there is no reason to believe that the exceptionally high oil prices associated with the Iraq-Kuwait conflict of 1990-91 should recur. Nevertheless, the days of exceptionally low oil prices are also over.

After a rigorous analysis of the supply and demand factors in the marketplace, the IMF projects that oil prices will remain stable over the medium term, when adjusted for inflation, but will continue to be vulnerable to the kind of volatility seen in recent months as a result of activities in Iraq.

Looking at the demand side of the equation, the IMF suggests that world consumption of oil in the period 1995-2000 will grow by an estimated 2 per cent a year, compared with 1 per cent a year in the previous five years. This is largely the result of the economic recovery which is now picking up momentum in the transition countries of the former Soviet Union and eastern Europe, as well as the rapid consumption in Asia.

The pace of demand will be partly offset by the increasing use of natural gas for power generation in industrial countries, as well as the decline of driving-age populations in Europe and Japan, with their rising age profile.

However, demand will rise in the countries in transition from centrally planned economies, with transport industries among the main consumers. Similarly, growth in oil consumption in developing countries - most notably China, where usage is climbing by some 5 per cent a year - will increase the pressure on demand.

With the demand side of the equation kept relatively taut as a result of the strength of emerging market economies, price levels are going to be determined largely by supply factors, as has been evident from the recent price bubble. On the production side, prospects appear to be reasonable over the medium term. Oil reserves are considered adequate and technology for extraction is improving. Outside the Opec countries, production is likely to increase as the output of Russia and the Baltic states begins to recover after major reorganisation and investment programmes. Moreover, within Opec there is considerable ability to increase production capacity, as Saudi Arabia has demonstrated when it has needed to make up for lost Iraqi barrels.

Herein lies the major uncertainty. If Iraq were allowed politically to return to full production status over the medium term, then Opec could potentially increase production by around 3 million barrels a day.

If Opec wished to hold the price up it would be able to do so, by ratcheting down production to offset the Iraqi supply - but this will be dictated more by the unpredictable politics of the Middle East rather than economic factors.

For the moment, however, major oil users will have to adjust to higher prices than has been the case in the mid-1990s. An analysis by London stockbrokers NatWest Securities suggests that the likely average price of crude oil between now and 2000 will be in the order of $18-$19 a barrel.

While that is higher than the normal levels seen in the 1986-93 period, it is not considered high enough to cause serious disruption to the global economy. It is the price peaks, which tend to be prompted by political developments, which will continue to catch out oil consuming businesses like airlines.

Alex Brummer

Source: Airline Business