Kurt Brouwer July 25th, 2008
If you want the simplest explanation of why oil prices have gone up, this chart should do the job.
The economy around the globe has been growing, but oil production flatlined. We’ll get into the reasons why demand has soared and why production has not kept pace, but this picture tells the story. However, the good news is that all of this is simply a problem of positive growth. The worldwide economic pie is growing and, due to that growth, demand for oil is increasing.
Oil is a commodity that drives our economy and demand for it is not very sensitive to modest price increases. Therefore, prices had to go up a lot in order to reduce demand. And, in many countries, demand has been artificially stimulated by government subsidies that kept the price of gas artificially low. This is true in China, India and other countries.
This report from the U.S. government’s Interagency Task Force on Commodities [emphasis added] makes several important points. Production has lagged behind economic growth worldwide. That alone would be an issue, but demand for oil has been artificially stimulated in China and other countries that subsidize the price. As a result, consumers in those countries were not affected by higher prices:
Interim Report On Crude Oil (Interagency Task Force On Commodities, July 2008)
…On the demand side, world economic activity has expanded at close to 5 percent per year since 2004, marking the strongest performance in two decades. Between 2004 and 2007, global oil consumption grew by 3.9 percent, driven largely by rising demand in emerging markets that are both growing rapidly and shifting toward oil-intensive activities. Also, some of the fastest growing nations also rely on price subsidies that hold down the prices of oil and refined products such as gasoline, which further boosts oil consumption.While global demand has proven strong, oil production growth has not kept pace. In the past three years, non-Organization of Petroleum Exporting Countries (OPEC) production growth has slowed to levels well below historical averages, and world surplus capacity has fallen below historical norms. Preliminary inventory data also shows that Organisation for Economic Co-operation and Development (OECD) stocks have fallen below 1996-2002 levels. Moreover, supply disruptions have adversely affected both world oil production and exports.
…Under such tight market conditions, it is often the case that only large price increases can re-establish equilibrium between supply and demand. Consequently, large or rapid movements in oil prices are not inconsistent with the fundamentals of supply and demand; such price movements, by themselves, do not indicate that prices have become divorced from fundamentals…
In an earlier post, we made this point as well. When supplies of a necessity such as food or fuel are tight, enormous price increases have to occur before demand falls. Prices go up (or down) in relation to imbalances in supply and demand. But, demand for some products like food and fuel is, in economic jargon, relatively inelastic. This means that demand for corn or gas does not respond quickly to price increases or decreases.
In the short run, those who eat corn products or drive cars are going to keep doing so in spite of prices increases. As a result, if there is a supply shortage of such a product (corn or oil products), the price increase has to be very large in order to reduce demand enough to get supply and demand back in balance.
Here is an excerpt from this post (Why Are Food & Fuel Prices Soaring?) that makes this point. The following quote is from Harvard economics professor, Martin Feldstein [emphasis added] in a piece he wrote for the Wall Street Journal:
Here is a simplified picture of what happened in the past year. The quantity of corn demanded by high-growth countries rose gradually, increasing eventually by an amount equal to, say, 10% of the previous total global level of corn consumption. Since the supply of corn did not increase, the price had to increase enough to reduce corn consumption in other countries by 10%. If it takes a 10% increase in the price to reduce the quantity of corn demanded in the first year by just 1%, it would take a 100% increase in the price of corn to offset the initial 10% rise in the quantity of corn demanded.
Yikes. A 100% increase for a food product such as corn seems outrageous, but if demand goes up, it takes a while for supply to catch up. After all, farmers can’t just pop out some more corn overnight. It takes an entire growing season. When it comes to oil, the process is similar. While producers such as Saudi Arabia can quickly ramp up production a bit, the development of new oil fields to implement large increases in production can take years. But, there is one advantage oil has over perishable commodities such as corn.
…The situation for oil is more complex, but the outcome for prices is potentially more favorable.
Unlike perishable agricultural products, oil can be stored in the ground. So when will an owner of oil reduce production or increase inventories instead of selling his oil and converting the proceeds into investible cash? A simplified answer is that he will keep the oil in the ground if its price is expected to rise faster than the interest rate that could be earned on the money obtained from selling the oil. The actual price of oil may rise faster or slower than is expected, but the decision to sell (or hold) the oil depends on the expected price rise.
…If the price of oil is expected to rise faster, they’ll keep the oil in the ground. In contrast, if the price of oil is not expected to rise as fast as the rate of interest, the owners will extract more and invest the proceeds.
Expectations. Producers of oil are pretty rational and if they think the price of oil is going up quickly, then they might be tempted to hold off on production increases. But, expectations can work the other way too. If the high price reduces consumer demand for oil products enough, then producers will begin to forecast falling prices. As a result, they may want to ramp up production now before prices fall much further.
The relationship between future and current oil prices implies that an expected change in the future price of oil will have an immediate impact on the current price of oil.
Thus, when oil producers concluded that the demand for oil in China and some other countries will grow more rapidly in future years than they had previously expected, they inferred that the future price of oil would be higher than they had previously believed. They responded by reducing supply and raising the spot price enough to bring the expected price rise back to its initial rate.
…Once this relation is understood, it is easy to see how news stories, rumors and industry reports can cause substantial fluctuations in current prices – all without anything happening to current demand or supply.
…Now here is the good news. Any policy that causes the expected future oil price to fall can cause the current price to fall, or to rise less than it would otherwise do. In other words, it is possible to bring down today’s price of oil with policies that will have their physical impact on oil demand or supply only in the future.
…Any steps that can be taken now to increase the future supply of oil, or reduce the future demand for oil in the U.S. or elsewhere, can therefore lead both to lower prices and increased consumption today.
When politicians say that we cannot drill our way out of the problem of high oil prices, they are clearly being disingenuous because, as Feldstein demonstrated, even a modest expected increase in the future supply of oil will have an immediate impact on prices today. Also, the current high price for oil will stimulate increased production naturally and it will also help reduce demand. Both effects are already well under way.
This chart from the ITF indicates that global demand for oil is still likely to go up, but only modestly. And, that increase comes largely from China which has recently reduced the level of subsidy for gasoline. If subsidies in China were lifted completely, I suspect demand there would fall as well. This chart from the ITF report indicates that demand in the U.S. has fallen dramatically as consumers, businesses, farmers and others have responded to high prices:
As we saw from the first chart, global production of oil has flatlined while demand has grown. Now, with high prices, we are seeing a slowing in the rate of consumption or demand and we are also seeing new sources of oil coming on line. However, we know that demand and supply for oil will be tight for many years to come as existing oil fields slowly decline in production and worldwide demand continues to grow due to continuing economic growth.
I believe that we are on the verge of developing tremendous new sources of energy — solar, wind, clean nuclear — but, we’re at least 10 years away from deploying those sources in a meaningful way (see A New Strategy for Energy Independence — T. Boone Pickens).
Therefore, we need to continue developing oil and natural gas fields and we should pressure our political leaders to do just that. Fortunately, politicians do know how to sense the public’s mood and they understand that support for increased development of oil and gas is soaring due to high prices. As this chart indicates, support for increased drilling was only 35% in February and now it is up to 47% and no doubt will continue going higher as long as gas prices remain high.
Source: Carpe Diem
There are forces opposing the development of new oil and gas, but I believe they are being shortsighted. We can develop these resources in environmentally responsible ways and we need to do so now. Fortunately, some development is underway and that’s very good news:
Interior Department Opens 2.6 Million Acres For Oil Exploration (New York Times, July 17, 2008, Felicity Barringer)
The Interior Department on Wednesday made 2.6 million acres of potentially oil-rich territory in northern Alaska available for energy exploration. At the same time, it deferred for a decade any decision to open 600,000 acres of land north of Teshekpuk Lake that is the summer home of thousands of migrating caribou and millions of waterfowl.
The decision will open up for drilling much of the northeast section of the Northeast National Petroleum Reserve-Alaska, holding an estimated 3.7 billion barrels of oil, Tom Lonnie, Alaska state director for the Bureau of Land Management, said in a conference call with reporters.
The northeast and northwest portions of the reserve could yield eight billion barrels of oil, he said.
Mr. Lonnie said he expected the first oil production to begin in the easternmost part of the reserve, west of the Colville River, from 2010 to 2012. A fully developed oil complex exists on state lands on the eastern banks of the river…
As we see, the supply of oil will be going up a bit as the new Alaskan fields come on line beginning in 2010. And, we also have seen that demand for oil products has fallen due to higher prices.
Individually, these changes in supply and demand are not hugely meaningful. But, millions of such decisions are being made each and every day. Oil producers want to produce more to take advantage of higher prices. Consumers want to use less because of high prices. These forces — supply and demand — operate all the time. As demand falls and supply increases, prices should stabilize. Who knows, they might even continue the recent downward momentum.
I do hope they do not go down too much though. That may sound contradictory, but I believe high prices for oil will stimulate the growth of alternative energy sources and, in the long run, that’s a good thing. See Oil Prices — Too Low For Too Long.
ITF Report via: Qando.net
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