China National Offshore Oil Corporation?s oil rig in Bohai Sea

The price of oil has gone up from $10 six years ago to nearly $60 a barrel now. Why is this so? A car-owner or taxi-driver in India would, of course, say that the prices of oil have been rising ever since he can remember. But this is not true. In fact, the inflation-adjusted world price of oil has been following a broadly falling trend over many years, except for the past one year or so.

Why this reversal of trend? Is it likely to continue in the future? And what are the likely consequences?

The price of oil is largely controlled by the Organization of Petroleum Exporting Countries, a cartel of the major oil-producing nations, through the imposition of production quotas on its member countries. But that does not explain why sometimes the price of oil falls and while, at other times, it rises.

Many factors lead to the instability of oil prices. First, some major oil-producing nations like Russia and Mexico are not members of OPEC and are not bound by any production quota. Second, even OPEC members sometimes cheat by producing more than their allotted quota. Third, governments in both oil importing and exporting countries try to influence the price and consumption of oil with the help of taxes, subsidies and regulations. Fourth, geopolitical developments (like the Iraq war or terrorist attacks on oil pipelines) have a role to play. Fifth, the demand for oil fluctuates with the seasons (an exceptionally severe winter or summer affects the demand for oil for heating or cooling purposes) and with the growth in the use of cars over time.

But what explains the recent sharp rise in global oil prices? The demand for oil has been steadily going up as a result of rising incomes in first-world countries and, more important, the rapid growth of car ownership in the two large developing economies of China and India. This did not cause a rise in prices so long as OPEC and other oil-producing nations could increase supply to meet this rising demand. But over time, the major oil-producing nations have mostly run out of excess capacity. It takes years and massive investment to build production (especially refining) capacity in oil. Most OPEC members had not increased capacity since, until recently, the price of oil was following a downward trend.

Surely, the production of oil can be raised over time in the future by investing in new oil fields and building new refining capacities. In fact, most OPEC members do not like to see the price of oil going up too much. The regimes in many of these countries depend on the United States of America and its allies for survival and do not want to antagonize them. Moreover, they fear that if oil prices go above a critical level, the world may slide into a recession, or a stagflation, which would adversely affect the demand for oil and oil products.

Even more worrying is the possibility that the Western nations would then go for a new generation of fuel-efficient cars which would, in the long run, erode the price-setting power of OPEC. Already major auto producers are experimenting with new technologies which will permit cars to be driven on alternative energy sources, like solar power, natural gas, bio fuels, electricity, and so on. If these technologies prove cost effective, then it would mean a drastic reduction in the oil dependence of the transport sector.

The question is: can OPEC contain the price of oil, even if it wants to? Despite occasional scares, most experts believe that the global oil reserves are large enough to last for all foreseeable future. But, the extraction of oil from new sources ? for example, from under the deep seas, below the Antarctic ice or sea shells ? is going to cost a lot more. Also, the extra oil that OPEC is going to produce will mostly consist of heavy high-sulphur crude which will cost more to be refined into a grade that will meet today?s stringent pollution standards. Most rich countries like the US do not want to develop refineries for fear of pollution. That means new refineries will have come up in less developed countries, a move that is subject to greater political risks.

All these imply that even if the world does not run out of oil, it will have to live with a higher price of oil. Unless, of course, there are technological breakthroughs in the auto sector which drastically reduce the demand for oil. But then, the magnitude of this reduction will have to be such that it offsets the steadily rising demand for private cars in the newly affluent countries like China and India. That does not seem likely.

What has been the impact of the recent sharp rise in oil prices? So far, it has coexisted with robust growth in most parts of the world. Nonetheless, many experts believe that a recession may eventually set in if the (real) price of oil continues to hit the roof. At exactly what point, nobody knows.

Why does the rising demand for goods, including oil, show no sign of slowing down yet? It may be partly because, unlike in the Seventies and Eighties when governments used high taxes and much stricter fuel efficiency norms to cut consumption, no such initiatives have been taken so far by the Western countries. Perhaps, they will be forced to do so if the oil prices continue their upward trend for some more time.

So far, the US government, under the leadership of George W. Bush and Dick Cheney (both of whom are said to have stakes in the oil sector), is using the rising price of oil as an opportunity to push for oil exploration in Alaska, which had so far been resisted by the environment lobby. They do not want to restrict consumption of oil as they fear it would stifle American growth and prosperity.

Cash-rich China, on the other hand, is going for takeovers of oil fields all over the world, including the US, to meet its ever rising energy demand. This has generated a political storm in the US, as many American Congressmen are not too pleased at the spectre of China taking control of vital global energy sources.

As for India, the domestic price of oil here is still largely administered. It depends on the world price and the discretionary taxes imposed by the government, which amounts to nearly 50 per cent of the price.

In short, the world may not see any shortage of oil (in the form of rationing or long queues at petrol pumps), but the days of cheap oil may well be over, at least in the medium term of three to five years. After that, it will depend on how much success there is in achieving greater fuel economy with new generation cars.