Crunch warning as oil nears $80

As oil prices approach last year's all-time high of $78.65 a barrel, the leading world energy body has warned that a major crunch looms in five years' time as booming demand outstrips supply.

In its monthly oil market report released today, the International Energy Agency predicts that pressure on oil supplies will ease next year. But in its medium-term outlook the IEA said a supply crunch will take hold of the market towards 2012 as demand rises faster than expected.

It predicts demand will rise by an average of 2.2% a year between 2007 and 2012, driven by strong economic growth, particularly in China, the Far East and India.

Ted Scott, manager of the F&C UK Growth & Income Fund, warns that the China factor can only accelerate: 'China is only a few years into its industrialisation programme and the number of cars in the country is still a very small fraction of those in the US. This could dramatically change in the next few years, hugely increasing demand for oil,' he said.

'There is also a growing political risk in the oil sector. Countries such as Russia and Venezuela are making it increasingly difficult for Western companies to access and export their oil.'

Supply, however, will not be able to keep pace. With nations outside the Organisation of Petroleum Exporting Countries adding only 1% to world supply each year, it all depends on Opec. And the IEA foresees that Opec will face capacity constraints.

Investment to develop new extraction techniques is also affecting profitability. 'It is becoming increasingly difficult, and much more expensive, to find new sources of supply for oil,' says Scott. 'The most accessible areas to have already been exploited and oil companies are being forced to explore less attractive areas. What this reports shows is that oil reserves have been generally overestimated.'

The IEA medium-term report set the oil market off into a nervy week, with Brent ticking steadily up from $73.80 to threaten the all-time high.

It stabilised at $77.27 by noon today with the release of the IEA's more optimistic view for next year. It predicts Opec's production capacity will rise by 1m barrels per day (bpd) and also that refinery capacity will expand sufficiently to meet increasing demand with more ease than in the past two years.

Ten Opec members began cutting production in 2006 to stem a drop in prices. The IEA has repeatedly urged Opec to raise supply and the report pointed to a higher need for the group's oil by the fourth quarter.

Opec officials maintain they are not to blame for near-record oil prices and point the finger at a global shortage of refinery capacity and international political tension.

The Financial Times noted in an editorial yesterday: 'In many ways, the rising oil price points to a market at work: demand is up, supply is lagging and prices rise. That high price should fuel a search for alternative sources of energy and lead to more exploration and exploitation of oil supplies.'

However, the IEA also warns that production and adoption of alternative fuel types such as ethanol and other biofuels is not sufficiently advanced to fill the gap within the next five years.

Economists and policymakers are growing increasingly concerned that the surge in oil prices will feed through into higher price inflation, leaving the Bank of England little option but to raise rates even higher in order to meet its long-term objective of getting consumer price index inflation back down to 2%.

Monetary policy committee member Dr Andrew Sentence earlier this week warned that rising world commodity prices would soon force the Bank into another rate rise to 6%.