The rise in crude oil prices is a worldwide phenomenon and Pakistan cannot remain immune to it. This increase in prices is a result of structural issues involving crude oil supply and demand and is not an anomaly. Oil prices are expected to remain at elevated levels for the remainder of the decade and Pakistan’s economy has to adjust to this new reality.

OPEC has generally enjoyed excess crude oil capacity to the tune of three to four million barrels per day. This excess capacity has now shrunk to about 1.5 million barrels per day and is at its narrowest in decades. Thus the world is experiencing a narrower supply cushion than usual.

Simple laws of economics would dictate that current record oil prices would cause a dramatic supply response. However, in our view three major reasons prevent this from occurring.

First, the world is experiencing aging of its crude oil resource base resulting in a dramatic increase in unit finding and developing costs and a slow production response. Back in 1956, a US geophysicist named M. King Hubbert proposed a theory that linked resource maturity with peak in oil production. He correctly predicted that the peak in US oil production will occur in the early 1970’s.

Some proponents of the Hubbert’s peak now believe that the world is in the midst of crude oil peaking. However, many other geoscientists believe that there are enough unconventional sources of oil available that can delay the peak in world’s oil production by twenty to fifty years. Nonetheless, there is significant evidence that suggests that a much higher level of investment is required today to find an incremental barrel of oil versus a decade ago.

Despite the need to invest more in crude oil exploration, most publicly traded oil companies have been extremely cautious in raising their investments. This leads us to our second point which is that most US based independent oil companies are still shy of investing their full cash flows into new exploration projects and are instead using their cash to buy back shares and to make acquisitions. Major oil companies are still using a commodity price deck of $20.0 to $25.0/barrel in setting up their exploration and development budgets. Thus the world is not seeing the level of reinvestment commensurate with a $50.0/barrel crude oil.

Finally, the infrastructure needed for crude oil exploration and development is in tight supply too which precludes any dramatic increases in drilling activity in the near to medium term.

Worldwide effective utilization of drilling rigs is now in the low-to-mid 90 per cent range, a very high level indeed. Since the construction of high end rigs require significant capital investment and substantial lead times, no significant capacity expansion is likely over the next few years. Similarly, other oilfield services required in any exploration and development effort are also in tight supply. Finally, there is a severe shortage of geologists, geophysicists and petroleum engineers in the western world and this is hindering the ability of western oil companies to boost their exploration, development and production programmes in a big way.

While the world faces bearish supply issues, the picture for demand is increasingly rosy in part due to explosive economic growth rates seen in two of the world’s most populous countries, China and India. According to data provided by the IEA, world’s crude oil demand which rose at a steady rate of about 1.0-1.50 per cent per year in the past decade, experienced a 2.30 per cent increase in 2003 and another 3.3 per cent rise in 2004.

Fuelling this growth was 10 per cent growth in Chinese demand in 2003 and another 16 per cent increase in 2004. Till now Chinese demand has been a small part of world’s over-all demand, but owing to its size and superlative growth, China is now becoming an important player in the demand picture and its role is likely to increase even more with time.

Current Chinese annual per capita crude oil consumption is only two barrels. In contrast, per capita annual consumption in the US is 26 barrels and in South Korea 17 barrels. Over time, if the Chinese consumption follows the pattern of South Korea, incremental crude oil consumption will be about 18 billion barrels annually, equalling 49 million barrels per day. This equals about 60 per cent of world’s current demand for oil. Crude oil consumption in another populous country, India, is set to grow as well.

India currently consumes 1.5 barrels of oil per person per year. As this country of a billion plus people grows economically at a six per cent plus per year rate and its people shift from riding bicycles to driving motorbikes and cars, the country’s per capita consumption will increase. There is very little chance that world’s crude oil resources can meet world’s crude oil demand if China or India follow a South Korea type oil consumption model. The most likely scenario is that oil prices stay high to slow down oil demand growth.

Given these supply/demand dynamics it is quite likely that crude oil prices average at prices well above those seen in the prior years. During the period 1995-1999, crude oil prices stayed within a range of $18-20/barrel for about 25 per cent of the time, and were below $12/barrel or above $26/barrel for only two to three per cent of the time.

During the period 2000-2004, crude oil prices stayed in the $26-$30/barrel range for close to 40 per cent of the time and went above $40/barrel for only about 10 per cent of the time. In light of the trends mentioned earlier, and owing to the risk of terrorism related supply disruptions in OPEC countries, it is quite likely that crude oil prices stay at elevated levels going forward with spikes into the $70-80/barrel level possible. It is highly unlikely that over the next five years crude oil prices would fall below $30/barrel for any extended period of time.

As an oil importing country, Pakistan may face huge cash outflow to finance its crude oil imports. It is, therefore, imperative that the government take quick steps to reduce its reliance on foreign oil. This can be done through increased investment in finding local sources of oil and gas, and by decreasing the demand for oil by encouraging the use of fuel efficient vehicles such as CNG driven vehicles and hybrid cars.

Renewable sources of energy such as solar and wind need to be explored, and the country’s hydroelectric potential needs to be fully exploited.