(Irish Independent 26th April 2004)

With the oil price remaining stubbornly high, the consensus tells us that oil prices will come down in the near term. However, all may not be as it seems.

Oil is no different than any other commodity or product, it depends on those two intrinsically linked characteristics of price and volume. There has been much debate recently about rapidly rising demand and sluggish potential supply.

Such debate is not new and history is littered with ‘experts’ calling the end of oil supply. During World Wars I and II, the oil price peaked on such fears.

Of course, those of us who remember queuing for petrol during 1973/74 will never forget that crisis, to the extent that we regularly check out the price of unleaded petrol per litre as we enter the local petrol station for our weekly refill.

Likewise, we remember oil at $10 per barrel in the late ‘90’s in anticipation of an oil glut. The dynamic of the oil market has not really changed over the last 40 or 50 years. The Oil Producing Exporting Countries (OPEC) make up 40% of world production and operate at varying degrees of capacity but usually around 80%.

For OPEC countries, it costs no more than $3 to produce a barrel but much more in other countries. Demand which was running about 75 million barrels per day is forecast to grow at 85 million barrels per day.

Interestingly, alternative types of energy production has not eroded the demand for oil. Wind energy, the electric car and the capturing of the power of waves still do not displace oil as the primary energy provider.

Of further interest is that as the oil price increased so too did demand. In the recent past, the oil price increase has become exacerbated by geo-political risk.

President George W Bush entered the Whitehouse four years ago, promising lower oil and hence petrol prices. His foreign policy has ensured anything but that, and yesterday’s announcement by OPEC that they will cut output by one million barrels per day, places greater pressure on the incumbent President.

This supposed tough stance with the cartel looks in tatters. On entering Iraq, it was suggested, possibly cynically, that the US was in search of oil to top up their Strategic Petroleum Reserve – a US emergency reserve. However, what has come to light is that Iraq has only “effective” reserves of 50% of previous estimates. Continued skirmishes in the region will not help matters, along with renewed Israeli – Palestinian violence, following the assassination of the Hamas spiritual leader.

These all ensure the world is an increasingly hostile place and oil as a proxy for this hostility will remain higher than expected. In his recent paper to the Financial Analysts Journal, Matthew R Simmons, Chairman & CEO of Simmons & Company International, Texas, also points out structural risks to support higher oil prices. He cites the International Energy Agency who forecast oil demand to jump from 75 million barrels per day in 2000 to 120 million barrels per day in 2030.

Furthermore, more alarmingly, the IEA carried out estimates on total investment to create this projected energy growth. They estimate $6trillion of capital expenditure is needed to expand daily oil and gas production.

A key assumption in the study was that over half of this extraordinarily large investment is needed to maintain existing refineries. Furthermore, in a more public domain, has been the reclassification of reserves by Shell from proven to probable, which has resulted in a reduction of these reserves by over 20%, with some possibilities of further downgrades.

The amount of oil that can be produced to what should be included in reserves has always been subjective. The Securities & Exchange Commission requires a conservative definition - an inexact science to say the least!

So where does this leave your average investor who holds long-term investments? The days of fossil fuel reliance are not coming to an end. In short, buying oil in the form of commodity or equity investment on bad days is a long-term strategy that should pay dividends.

Patrick Lawless is MD of Appian Asset Management.