Tuesday, April 18, 2006

How High Will Oil Prices Go?

It seems that Larry Kudlow was right, sort of, when he in March 2005 predicted that "$55 oil won't last". It didn't last-it have since risen to an all-time high of $72.

The oil price boom is part of the general boom in commodity prices that we have seen recently. Many other commodities have risen as much or more as oil in price, although the oil price surge have a much greater effect since it is the most important commodity in terms of impact on the world economy.

In the long run, oil prices simply cannot continue to increase this fast. Rising prices will both encourage increased exploration and encourage the use of alternative sources of energy, such as nuclear power and hybrid cars. And as prices go higher and higher, the pressure to increase production and switch to alternative sources of energy will intensify. And as oil prices at these levels will slow world economic growth, this will naturally reduce demand.

And if the combination of rising interest rates and rising commodity prices causes a recession in America, something which together with the protectionist policies which would likely follow, this could seriously reduce growth in China, whose rising demand for oil are one of the main reasons for the price increase, this could cause a significant correction in oil prices.

However, there is a significant risk that oil prices will go even higher before they start to turn lower, particularly if there is a military confrontation between the United States and Iran (the world's fourth largest oil exporter after Russia, Saudi Arabia and Norway)) over Iran's nuclear weapons program. While the direct effects of an American attack on Iran's nuclear facilities on oil supply from Iran will be limited, the counter-strikes that the Iranian leaders have pledged could cause a larger scale confrontation which would cut off Iranian oil from the world market, something which in turn could cause oil to rise to $100 per barrel or so.


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