Little relief in sight from high oil and gas prices

High oil and gas prices are a nightmare for central bankers because they stoke up inflationary pressures in the leading industrialised economies and inflict a heavy burden on developing countries that can ill-afford to pay high prices for energy.

"The main upside risk to our current, already robust, inflation projection is a rise in utility bills in the new year on the back of recent strength in wholesale gas markets," said Alan Castle, an economist at Lehman Brothers. "Were this to happen then our CPI forecast could be close to the 3% letter-writing zone by the middle of next year."

Castle was referring to the fact that the Governor of the Bank of England must write a letter to the Chancellor of the Exchequer if inflation rises above 3%.

Oil averaged $31.50 a barrel in 2003, $41.50 a barrel in 2004 and $56.70 a barrel in 2005. The trend continued in 2006, with $66.20 a barrel, and $72.50 in 2007.

Several leading investment banks are predicting that the average price for 2008 will be above the 2007 figure with Paris-based Société Générale and Deutsche Bank forecasting average prices of $80 a barrel in the new year.

The estimate from Goldman Sachs has come in higher than most of its counterparts with the Wall Street stalwart raising its price forecasts for 2008. The investment bank said US crude was likely to average $95 a barrel, an increase of $10 on its previous forecast.

Goldman, the most active investment bank in energy markets, added that the price could leap to $105 by the end of the year. That would mark an all-time high for oil prices. The current record was set in 1864, when the Pennsylvania oil boom pushed prices to an inflation-adjusted $104.35 per barrel.

Goldman, which has long held a bullish view on oil, said it expected the Organisation of the Petroleum Exporting Countries to keep a cap on production that would offset the bank's expectations of slower growth in oil demand. Goldman now predicts world demand to rise by 1.7 million barrels per day in 2008, down from 1.9 million previously.

In December, Opec members rejected calls from consumer countries to raise its production levels, voting instead to keep output steady. At that point, oil prices were dropping back from peaks of nearly $100 per barrel hit on the back of supply concerns and the weak US dollar.

Not so bullish is Katherine Spector of JP Morgan in New York. Her estimate came in on the low side. She forecast an average price of $68.2 a barrel.

Spector is concerned that the US economy may take a steep slide in 2008, curbing the demand for oil.

However, Peter Beutel, the president of the US energy risk management firm Cameron Hanover, thinks prices will go up rather than down in 2008. He said traders working for big hedge funds, who jumped out of the oil market in late November, appeared to have returned to buy crude futures. "It suggests that prices may now want to make another run at $100 (a barrel) and possibly beyond," Beutel said.

Some analysts believe strong demand for petroleum products in 2008 and geopolitical tensions, particularly in the Middle East, will also keep prices robust and have the potential to drive them above $100 a barrel.

Industry experts point to simmering tensions between Turkey and Kurdish separatists in northern Iraq and the recent incursions by Turkish troops into Iraq to fight rebels of the Kurdish PKK movement. There is a danger that the dispute may escalate and threaten oil output in the wider region - Iraq, Iran, Kuwait and Saudi Arabia between them account for about 20% of global supplies.

In particular, there are concerns about potential Kurdish reprisals on an important pipeline in Turkey, which delivers 700,000 barrels a day from Azerbaijan to the port of Ceyhan.

Elsewhere in the region, Iran's push to acquire nuclear power and, many believe, nuclear weapons, has sparked concerns it could use its own oil supplies as a bargaining chip in any future showdown.

Barely-veiled threats from Washington, suggesting that military action remains a live option, have further accentuated fears of war in the area.

Militant violence in Nigeria's largest oil-producing region and recent violence in Afghanistan and the Yemen has also served to inflate prices and could do so again.

The value of the dollar will also have an impact on the direction of crude prices in the new year.

Oil futures offer a hedge against a weak dollar, and oil futures bought and sold in dollars are more attractive to foreign investors when the greenback is falling.

Many analysts cite the Federal Reserve's recent rate-cutting campaign, and its role in depressing the value of the dollar against other currencies, as a major factor behind oil's rise this year to record levels above $99 a barrel.

Meanwhile, demand for oil is at an all-time high, fuelled by the continued breakneck economic expansion of the Indian and Chinese economies.

With more than a billion people in each country, and both economies growing fast, manufacturers and consumers are sucking in energy at an ever-increasing rate.

The International Energy Agency raised its forecast for world oil demand growth in 2008 by 170,000 barrels a day to 2.5%, compared with 2.3% in its previous report. It said overall demand was now expected next year to reach 87.8 million barrels a day.

The security watchdog for the Organisation for Economic Co-operation and Development (OECD) said its upward revision was based on an expected increase in demand for ethane and other petrochemical feedstocks in the Middle East, notably Saudi Arabia.

The forecast assumed continuing robust oil demand growth in non-OECD countries, where subsidies protect people from the impact of high oil prices, and normal winter weather.

A separate Opec report that also slightly raised 2008 demand.

Barclays Capital, which is bullish on oil prices, said economic concerns were weighing on oil market sentiment, but most data suggested continued solid growth in oil demand. "We believe markets are underestimating the true extent of the underlying physical tightness," analysts at the bank said in a research note.

Not surprisingly, bearish analysts take a bleaker view of the prospects for future demand. They have questioned optimistic estimates of demand growth in 2008, given recent signs of a global economic slowdown.

A recent US Energy Department report lowered global oil demand predictions for the new year, and recent US Energy Information Administration inventory reports have shown demand growth is tepid at best. Meanwhile, Opec supplies grew late last year.

Mike Wittner, an oil analyst at Société Générale, was also unimpressed by the IEA outlook. "We are more pessimistic than the IEA on demand growth for 2008," he said.

Predicting oil and gas prices is often difficult - it is not an exact science - but it appears there is little relief in sight for UK motorists or industry.