Wednesday, June 6, 2012

The driver of oil prices....

The driver of oil prices....
By Hossein Askari

This is the third article in a special series on oil and the Persian Gulf.
Part 1: Riddle of the sands
Part 2:
The sweet and sour of oil

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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