When do we start talking about oil?

Yesterday the government announced its latest inflation report, and inflation is at 3.7%. Since the government has strict targets to keep inflation below 2%, the governor of the Bank of England had to write a letter to the chancellor explaining why it’s running high. In his letter, Mervyn King blames the oil prices, the restoration of the 17.5% VAT rate, and the depreciation of the pound. None of those things were unforeseen, and all three are considered temporary. But is that realistic?

“I am grateful for your explanation” says Chancellor George Osborne in his official reply. “A number of temporary factors have contributed to this elevated rate of inflation, including the VAT rate rise in January 2o10 and high fuel prices.”

As far as the government and the Bank of England are concerned, the high oil price is temporary, but I’m not sure that we can assume that its current price is an aberration. A few years ago, a barrel of oil for under $50 was normal. Not any more. It’s noticeable that after the 2008 spike and crash, the price didn’t drop back to ‘normal’. It bounced back up to around $70 a barrel, where it has remained all year. It hit a high of $89 at the beginning of the month, and then this week dipped below $70 for the first time.

This week’s fall looks like speculation, as it coincides with bad news about the Euro. (People speculating on the oil price are guessing there won’t be a swift recovery in Europe, so oil demand won’t be rising in Europe as expected – time to sell those oil futures) The market should be correcting itself as well – global economic recovery has been modest and the oil companies are running a surplus at the moment, both of which should pull the oil price down. The fact that the price hasn’t fallen any lower, despite the low demand, reveals something a little more uncomfortable: it just costs more to drill oil these days.

Rembrandt Koppelaar, in the May issue of Oilwatch monthly, points out that the break even point for some US producers is $63 a barrel. It’s even worse for Canada’s tar sands, which need a price of $85 before they start to make any money. And that’s the bigger problem. As we consume the conventional oil, we’re pushed ever further into the mountains, the Arctic, to the tar sands or out to sea to find new sources of oil. Those are expensive ways to keep the pumps flowing.

It’s quite possible that the oil price will tumble further as people worry about the economy – instability is the only certainty at this point – but it can’t stay low. And that’s what the government and the Bank of England seem to be missing – that there is no cheap oil ‘normal’ to return to. They may need to think more creatively about inflation.

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