July 16, 2008 | posted by Michael Baxter in Oil |

From peak to trough oil fell by over $10 a barrel yesterday, and this morning when we took our daily reading stood at $138, that’s 6.8 dollar a barrel lower than the same time yesterday. (Prices from the New York Mercantile Exchange)

Admittedly, in early June oil was cheaper than this. For that matter, until five weeks ago the current price would have been an all-time record. Even so, these days we need to make the most of falls like this, and ask, is this the first stage in the fall in the price of oil to more sustainable levels?

The reasons given for yesterday’s price falls were manyfold. OPEC helped. Yesterday it said that thanks to the declining economic outlook, demand for oil in 2009 would be less than it originally estimated. But then again, it wasn’t much of a downgrade. It had previously expected global demand to rise by 1.28 per cent next year, now it thinks it will rise merely by 1.2 per cent. So, whoopee to that.

Ben Bernanke helped too. He helped by telling bad news. He said high energy prices are acting as a drag on the US economy, and limiting US households’ purchasing power. To which analysts looked up in surprise and “oh, hadn’t thought of that.”

George Dubya helped too. He wants to lift the ban on drilling for oil in coastal waters, although his decision has to be ratified by Congress. The ban that had been in place since 1990 when a certain George Bush senior was President.

The ban was implemented after the Exxon Valdez spillage disaster (was that really 18 years ago – ed), although has never applied to coastal waters in the Gulf of Mexico.

But then again, what difference will that make? It will take years before oil will actually flow, and in the US many were quite dismissive of the move. “If offshore drilling would provide short-term relief at the pump, or a long-term strategy for energy independence, it would be worthy of our consideration,” said a spokesmen for Barack Obama. “But most experts, even within the Bush administration, concede it would do neither.”

In fairness to George Dubya, who remember comes from Texas, the state of Dallas and JR Ewing, he was well aware of the time lag between lifting the offshore drilling ban and oil availability, but argued it would help lower the price of oil anyway, because when markets price oil they take into account future supply. Remember, the futures markets are supposed to discount future flow, which is why talk that we may or may not be approaching peak oil in a few years’ time is relevant to the price now.

There are, however, certain other factors that will have a much more significant impact on the price of oil over the next few years.

Firstly, there’s the slowing US and European economies. Surely, by reducing its estimate of how demand for oil will grow next year by such a small amount, OPEC has grossly underestimated the effect that oil at $130 plus is having on western economies.

At its current price, the price of oil is hurting, really hurting. It is inconceivable that western demand for oil will not fall dramatically over the next few years as a result.

But there are two other key factors too. One in favour of oil falling, one against.

The high price of oil will also hit international trade. China imports goods, does a bit to the goods it has imported, and then exports them. It is like that these days. The flow of trade is a hugely complex web, and the cost of transport is the key. If you like, transport is a little like trade’s bandwidth.

The cost of trade is in part determined by the price of oil, and in part due to other factors, such as containerization in which one global standard was defined for the size of all crates used for transporting goods. But as oil surges in price, this bandwidth will clog up. International trade will be hit. Global economic growth will slow, and demand for oil will fall.

But the other factor, that could work in the opposite direction, is the vulnerability of the dollar and sterling to further falls.

Both countries now have wafer-thin foreign reserves. As Ambrose Evans-Pritchard argued in the Telegraph this morning, if foreigners lose patience with the constant flow of profit warnings and losses coming out of western banks they may stop lending us money altogether. This could lead to big falls in our currencies. In the long term this may be no bad thing. In fact, it could be a very good thing, since it will help correct the global imbalances and enable the US and UK to expand through trade, rather than borrowing. But in the short term it will hit the economies hard, very hard.

If the dollar and pound fall much further, regardless of how much less oil we demand, the price of oil valued in dollars and sterling will continue to rise.