Supply and
demand are fundamental drivers of oil prices, but
other factors play their role - speculation, the
dollar's exchange rate, political disruptions,
conflicts, the Organization of the Petroleum
Exporting Countries.
In the figure below,
the two lines represent the long-term trend in oil
prices, 1861-2010; the dark green gives prices as
they were in the dollars of the day and the light
green gives the same prices in
what we call constant
dollars, that is adjusted for inflation and thus
more logically comparable from year to year.
One thing is clear - over this long period
of roughly 150 years, oil prices adjusted for
inflation (in 2010 dollars) have been in the
$10-30 range for all but about 35-40 years, which
were made up of three periods highlighted by three
major peaks in prices - in 1860-1861, 1979-1980
and 2007-2008.
Source: BP Statistical Review of World
Energy, June 2011
Let's start by stating
the obvious. Oil prices, like all other prices,
are driven by both supply and demand. On the
supply side, an increase in the immediate or
short-run supply of oil is limited by the
available excess capacity (of a particular type of
crude) and by the oil that is stored in strategic
reserves, company reserves and on tankers.
The long-run supply of oil is not fixed.
As oil prices rise, a number of related activities
are encouraged on the supply side. New
technologies are developed. New areas are explored
for crude. New fields are developed. Producing
wells are brought on line in the new fields. More
crude is produced from existing fields using new
technologies. That is, in time, installed capacity
to produce oil could be increased and more oil can
be produced.
But can this go on
forever-higher oil prices encouraging new
technologies and exploration activities to
increase global oil output? No. While new fields
come on stream, older fields are depleted and stop
producing.
It would appear that at some
point these opposing forces-additional production
from new fields and decline in production from
existing fields will be in balance and at some
point thereafter global oil output will likely
decline. Here is the 64 million dollar question.
Will readily accessible sources of crude (even
with technological advances) be exhausted,
resulting in declining oil production and
ever-rising prices, and if so, when? In other
words, is there such a thing as "Peak Oil", and if
so, when will it occur?
While we cannot
provide a definitive picture of the long-run oil
supply outlook, we can provide some comments. As
oil prices rise, energy conservation increases,
reducing demand for oil. Oil is used more
efficiently. Similarly as oil prices rise, other
energy sources will be increasingly substituted
for oil - although within limits, especially in
the short run, as substitutes for oil in
transportation are not readily available.
But still the key point is that as the
demand for oil increases and oil prices rise,
helpful factors both on the energy supply and
demand side reduce the pressure on oil supplies.
We should note that while new sources of
conventional crude come on line (as production in
older fields decline), production of
non-conventional crude (tar sands and shale)
increase and alternative energy sources
(conventional natural gas, shale gas, solar, wind,
and so forth) increasingly substitute for oil.
We predict that shale gas will become a
critical factor in global energy supplies because
of sizeable reserves, diverse sources of supply
and because it will provide the cheapest way to
combat global warming (with environmental concerns
that must be addressed). Already shale gas
availability may have impacted natural gas prices
to such a degree that the historic relationship
between oil and natural gas prices has become much
less discernible.
What about oil demand?
The demand for oil, as with anything else, depends
on its price, the price and availability of
substitutes (including mass transportation),
climatic conditions, government regulations and,
possibly most importantly on gross domestic
product (GDP).
The production of a unit of
national economic output, or GDP, requires some
energy input, with countries invariably using
different amounts of energy depending on what they
produce and their energy efficiency. It is for
this reason that global economic growth is such an
important determinant, or driver, of oil prices.
Somewhat similarly, rising energy prices
impact global economic growth and are an adverse
shock to economic growth, a shock whose impact has
been somewhat reduced over the last 30-40 years as
countries have improved their energy efficiency
(an issue that we will address later in more
depth).
Besides the basic forces of supply
and demand, a number of related factors have been
also received attention as important determinants
of oil prices.
To some economists, US
Federal Reserve monetary policy plays a key role
in determining oil, as well as other commodity,
prices.
The more the central bank prints
money, the higher the demand for goods and the
more intense the speculation. Knowing that money
is depreciating at a fast rate, consumers and
producers become speculators and develop high
inflationary expectations. This means that
producers withhold commodities anticipating higher
prices around the corner. Similarly, consumers
rush to buy and store commodities in anticipation
of price increases.
In the case of oil,
while producers can keep oil off the market in
anticipation of higher prices, it entails a cost.
For consumers to hoard oil, they incur a storage
cost.
Speculation on futures markets could
potentially increase price volatility but not
long-term prices. If a speculator buys an oil
futures contract, the purchase adds to the demand
for oil. But if the speculator does not take
delivery, use the oil, or take the oil off the
market and store it, that is sells the futures
contract before maturity, then there is no net
addition to demand and it is difficult to see how
oil prices (as opposed to price volatility) are
affected.
What about the impact of the
value of the dollar (the dollar's exchange rate)
on oil prices?
Oil prices are quoted in
dollars. Ultimately, it makes no difference how
oil is priced - in dollars, euros or yen. But the
price may go up or down and by differing amounts
in differing currencies because of exchange range
movements. Here is why. Oil is a global commodity,
with prices roughly the same the world over, and
allowing for any differences due to transportation
cost and taxes.
If oil is priced in euros
while the dollar depreciates relative to the euro,
then the euro price of oil must fall by roughly
the extent of the euro's appreciation to keep
prices globally the same. Looking at it somewhat
differently, I quote you a price in euros and tell
you its dollar equivalent but if tomorrow the
dollar looses value, then the dollar price that I
want for my oil will be higher but the euro price
will be the same.
Consider the two recent
price peaks (1979/80 and 2007/08). The first was
largely due to the Iranian Revolution and then the
onset of the Iran-Iraq War, leading to disruption
in supply and the some panic hoarding of crude.
Iran was a more important exporter of oil at that
time than it is today and there was insufficient
excess capacity around the world to immediately
compensate for any shortfall. But in time, and
although the Iran-Iraq War continued with further
supply disruption, oil prices (in dollars)
declined dramatically in the course of the decade.
More Saudi and other sources of crude came
on line, the dollar appreciated (with the
tightening of US monetary policy) and global
economic growth slowed down reducing the demand
for oil.
The most recent (dollar) price
peak was in large part driven by a rapidly growing
world economy and a depreciating dollar.
NEXT: OPEC into the driving
seat.
Hossein Askari is
Professor of Business and International Affairs at
the George Washington University.
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