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Since the seventies, crude oil prices have experienced
significant fluctuations. Behind these price fluctuations were,
among others, geopolitical factors impacting negatively on
political stability in the Middle East, and fluctuations of
supply and demand for crude oil determined by some ‘first’ world
economic structures.
Major players in the world oil market are OPEC and non-OPEC
countries. OPEC oil production is determined by the world’s
demand for oil and non-OPEC production. In recent years non-OPEC
production growth has been slowing down. Due to this decline in
non-OPEC production, the market share of countries in OPEC is
presently increasing faster than in the last few years.
The pricing of world oil dynamics has also changed since the
1970s, where OPEC and other oil producing countries were able to
set government selling prices (GSP). Recently, the easing in
supply and demand balances and the development of spot and
future markets, has led to a shift from GSP price setting to a
new formula that better reflects a supply and demand mechanism.
The market -based pricing formula has become the most dominant,
where prefixed adjustment factors are added to or deducted from
the price of a benchmark crude oil cost, fixed for each of the
three major oil markets: Asia, USA and Europe.
As the world economy now grows, world oil demand has increased
proportionately, despite the variation in demand between
different regions. Figure 1 shows that in developing countries,
growth of demand for oil is higher than that of the OECD. Even
though the latter represents 60% of the world oil demand; their
average annual growth in oil demand is 0.7%. Meanwhile, in
developing countries the average growth has been as high as
4.1%. Global demand for oil reached 85.7 million barrels per day
in 2007, a modest 1-percent increase over the 84.9 million
barrels consumed daily in 2006, as shown in Figure 2.
High Oil Prices
There are many factors behind the increase in oil prices. Some
of these factors follow:
I. Supply and Demand Factors
The recent surge in world oil prices, Figure 3, is largely
attributed to an imbalance between supply and demand. Production
has been stalled since 2005 at 85 million barrels a day, while
economic growth, especially in China and India, has pushed
demand ever higher. The China-led oil demand growth has driven
both OPEC and non-OPEC oil producing countries to increase
production accordingly. OPEC’s surplus oil production capacity
has thus declined, deepening the concerns over a tighter
supply-demand balance in the world oil market. In addition, fuel
subsidies in the local markets in China and India have created
cheaper oil prices for their consumers; consequently, inducing
more oil consumption and thereby giving the producers no reason
to reduce consumption so that prices could level off or drop.
The world oil market is characterized by supply rigidities.
These rigidities are attributed to soaring investment costs
(technical supply rigidity), to oil investment response lag
time, and to geological factors. As Figure 4 shows, world oil
supply across different regions in the world has not
significantly increased in order to match the ever increasing
demand across the world.World crude oil demand is characterized
as being extremely inflexible on price in the short term. Price
elasticity of demand is estimated to vary only between -0.01 and
-0.04. This means a considerable increase in oil price would
have only a small negative impact on oil demand. On the other
hand, world crude oil demand is identified as having high income
elasticity: if the technical coefficient between crude oil and
real GDP is fixed in the short term, then income elasticity
could be close to one. Despite this however, econometric
estimates show that short-term income elasticity ranges have
been between 0.2 and 0.4. Therefore, crude oil supply rigidity
combined with an expanding world demand for crude oil, has
resulted in growing demand-supply imbalances. Given price
inflexibilities of both oil demand and supply, a small excess
demand (supply) for oil would require large changes in oil
prices to clear markets.
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In addition, there are other supply factors specifically related
to the US government: restrictions on extracting oil from
various areas in the United States for environmental and other
strategic reasons.
Also, as a related issue to supply and demand imbalances, is the
lack of transparency in oil market statistics. Non-transparency
in production and demand data by some countries, may
 distort
the market mechanisms of pricing. Underreporting of actual
production, can drive prices higher as traders assume that
supply is lower than it actually is. Accordingly, greater
disclosure of accurate statistics help markets set prices that
actually reflect supply and demand.
II. US State of Economy and Federal Policies
High oil prices can be a repercussion of US macroeconomic policy
measures to offset recession; by this one can refer to the
hidden contribution of the Federal Reserve expansionary monetary
policy. Empirical research has shown that the depreciation of
the US dollar is coupled with increase in the price of oil
commodities and has shown that five of the last seven U.S.
recessions were preceded by significant increases in the price
of oil. As world oil trade is typically denominated in dollars,
any depreciation in the dollar is accompanied by an increase in
the oil price to compensate for the loss in the dollar value
against other international currencies. In return, dollar
depreciation increases demand for oil in countries with
non-dollar appreciating currencies, therefore keeping oil prices
high.
Due to the US recession, an expansionary monetary policy has
been adopted by the Federal Reserve to stimulate or activate the
US economy. The main tool of expansionary monetary policy is the
lowering of the interest rates; such policy should increase
money supply. The increase in the money supply thus supports
initiation of various new projects, which sets the foundation
for additional demand for various commodities, including oil,
and inducing price increases. Also, increases in the money
supply are assumed to encourage unproductive activities
(mal-investments) that would not have been previously undertaken
had the interest rates not been reduced. The massive increase in
the price of oil which is currently being observed, therefore is
a manifestation of a severe misallocation of resources.
III. Speculation Factors
A different cause of reasoning for high oil prices dismisses
attributing the increases in oil prices to the aforementioned
imbalances between supply and demand. Many discount these
imbalances as there is supposedly enough oil production in the
world and there are yet more oil fields coming online. In
addition, one of the key oil consuming nations, the USA, is
experiencing a significant drop in demand mainly owing to the
recent deepening economic recession. China, on the other hand,
consumes only a third of the oil the US does. The world,
presently, will witness only a minor rise in import demand
compared to the total daily world oil output; therefore, many
researchers state that recent increases in oil prices can not be
attributable to imbalances between supply and demand.
The proponents of this theme suggest that, about 60% of the
recent oil price increase is pure speculation, as the oil price
today, is determined in the trading rooms of enormous financial
institutions like Morgan Stanley, JP Morgan Chase, Goldman
Sachs, Deutsche Bank, Citigroup, or UBS, respectively. They
argue that huge profits on oil futures are being made. Another
factor encouraging speculation in oil futures is the unregulated
future market; as regulation allows a speculator to put up only
6% of the total value of his oil futures contract, thus the low
cost involved.
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