A primer on oil prices...

Here's a nice overview about oil prices.

It is commonplace to blame rising oil prices on industrial expansion in China, but that is a misleading exaggeration. Long before China's rediscovery of capitalism, earlier Asian Tigers accounted for a rising share of world petroleum demand. From 1978 to 2004, oil consumption rose 28.6 percent in the world but only 8.9 percent in the United States. That difference was exemplified by a 344 percent increase in South Korea's oil demand.

The United States still accounts for 25 percent of world oil consumption, but a declining 10 percent share of oil production. China accounts for 8 percent of consumption and 4 percent of production. China looms much larger, however, in terms of the incremental increase in demand. The IEA estimates China will account for 25.8 percent of this year's increase in demand and the United States will account for 14.6 percent. This leaves nearly 60 percent of the year's added demand coming from the rest of the world. Or maybe not.

Just as oil market pundits typically ignore the 60 percent of petroleum not going into passenger cars, they likewise ignores the 60 percent of incremental oil demand not coming from China and the United States.

Recall how regional industrial contraction collapsed the oil price in 1998 and 2001, then examine the last pages of The Economist to see what happened to industrial production over the latest 12 months. U.S. industrial production looks strong -- up 2.7 percent in May -- but that same figure a year earlier was up 4.8 percent. For Japan, industrial production is up only 0.6 percent, though a year ago it was up 8.3 percent.

Countries that were experiencing industrial increases of 12 percent to 22 percent a year ago -- such as Taiwan, Brazil, South Korea and Singapore -- are now up only 1 percent to 4 percent. For the Euro area, industrial production is down 0.1 percent. For Britain -- which exports oil -- it is down 1.9 percent. For Mexico -- which exports oil -- it is down 4.7 percent.

The Organization for Economic Cooperation and Development (OECD) tracks all major economies plus one mid-sized economy (Mexico) that accounts for 13.7 percent of U.S. exports. A six-month trend of the OECD leading indicators was up 7.5 percent at the start of 2004, but has since fallen to minus 0.5 percent this April.

Want the bad news first? High oil prices have already slowed industrial production in many countries, even China and the United States to a lesser extent. Leading indicators point to wider and deeper trouble ahead.

The good news is that oil prices have proven very sensitive to industrial production, so this problem is self-limiting. Cost-squeezed industrial firms -- not necessarily in the United States -- will be reducing production and thereby reducing world oil demand and prices.