Soon after the invasion of Iraq in March 2003, oil prices fell back to around $25 (£12.53) a barrel. Then they steadily increased, reaching their peak in October 2004, as demand increased faster than supply amid growing political instability in Iraq, Saudi Arabia, Nigeria and Venezuela. Storms in the Gulf of Mexico and the collapse of Yukos Oil in Russia also exerted upward pressure on the oil price. So what could happen to oil prices now and what does it mean for asset prices?The long-term oil price is determined by supply and demand. Currently, global oil demand is running at about 84 million barrels a day. Last year’s average demand was 82.4mbd, an increase of 3.3% over 2003. This represents a significant jump in demand. While the global economy had a strong year, China was the biggest driver of oil demand growth. Of the 2.6mbd growth in 2004, China increased demand by 0.9mbd. In other words, China accounted for 35% of the increase in demand for oil in 2004. China’s industrial expansion in 2004 saw a phenomenal growth in its demand for crude oil. This surge in demand was exacerbated by power shortages. The outlook for growth of global demand for oil in 2005 is largely dependent on growth in China. China is not expected to continue growing at the same pace and global GDP growth also looks to be falling back into line with trend growth in 2005. At the same time, growth in oil demand from other countries, such as America, should moderate. As a result, oil price demand pressures should ease as the year goes on. As the supply/ demand situation has become tighter, an additional premium has been placed on the different quality of oils. Sweet crude oil (light, low sulphur content and easily distilled to petrol and heating oil) has been in demand and therefore the price of oils such as West Texas intermediate (US benchmark crude oil) has rallied more than most. As oil producers have increased output, the extra oil has largely been sour (heavy, high-sulphur and less easy to refine) and therefore the spread between heavy oils such as Dubai, and light, such as WTI, has increased. As prices fall back, these spreads tend to narrow to more reasonable levels. However, additional oil supplies need to be in appropriate oil types to ease pressure on prices. In 2004, the world pumped an average of 83mbd and the Organisation of Petroleum Exporting Countries supplied 33mbd (40%). This illustrates the importance of Opec in the global supply picture. Opec also has the largest excess capacity, largely in Saudi Arabia, and has used this to try to exert some control on global supply and hence prices. Opec alone has projected supply growth, which will cover two-thirds of projected global demand growth, and has started cutting production to reflect its optimistic stance on spare capacity and buttress prices. The excess supply chart below shows the trend in supply and demand conditions over the past five years, and a projection for 2005. It should be noted that these conditions are not at extreme levels and excess capacity actually increased last year. The International Energy Agency has global capacity growth projections in the region of 1.5% per annum, which, accompanied by moderating demand growth as discussed earlier, should ease pressures on prices. There is no doubt that the tight supply/demand situation has pushed up prices, but the creation of a substantial “risk premium” has also increased price volatility. This risk premium is a reflection of geopolitical concern (Iraq, Saudi Arabia, Nigeria, Venezuela, Yukos and so on) and other factors such as storms and hurricanes. Speculators and hedge funds have used geopolitical events to push up prices. As speculative positions have fallen back, so has the oil price. Financial markets became less sensitive to the news of large oil price fluctuations as investors realised that the impact on economic growth would be minimal. This relationship can be seen in the chart above, which shows the falling correlation between oil prices and equity markets in recent months (the same can be seen for bonds). This low correlation between oil prices and asset prices should continue going forward. In summary, current supply constraints are such that near-term fluctuations in the oil price are inevitable. Over the longer term, as global industrial demand growth stabilises, the growth in the demand for oil falls, and supply steadily grows, oil prices will head down towards $35, where they will find a firmer footing. This will remove a risk for global markets and leave them to focus elsewhere.