In the aftermath of hurricane Katrina, oil prices went through the roof, reaching record highs of $70.85 per barrel (The Economist, 2005a). This sudden surge coupled with the fact that increased demand had already pushed the prices above $60 per barrel before Katrina hit has left everyone scratching their heads as to where its headed next. One of the predictions made by analysts at Goldman Sachs says that oil will fetch an average of $68 a barrel next year and $60 for the next five years (The Economist, 27 August, 2005, p.66). Its imperative to understand why the prices have risen, how they compare with previous historical highs and the role played by OPEC (Organization of the Petroleum Exporting Countries) before making any comment on how much more or less this proverbial Black Gold will cost in the near future.
OPEC & A brief history of oil prices (1971-1999)
The Organization of the Petroleum Exporting Countries (OPEC) is an intergovernmental organisation and one of the publicly known cartels; formed in 1960 in Baghdad. It currently has 11 member countries – Iran, Iraq, Kuwait, Saudi Arabia, Venezuela, and Nigeria being some of them. By 1971, a decade following its inception, OPEC managed to establish a control over the oil markets in terms of oil production and prices. OPEC since then has effectively dominated the oil market with the ability to influence the oil prices even though some of the recent producers are not members (e.g. UK).
OPEC policies in relation with the world events (Israel/Egypt war in 1973 and Iran/Iraq war 1980) have led to at least three major crises in the past (Williams, 2005). Oil prices quadrupled from $3 per barrel in 1972 to over $12 per barrel by the end of 1974 further increasing to over $35 per barrel in 1981 (Williams, 2005). These led to a global recession. Through 1981-1990 the oil prices fluctuated quite a bit, but a general downward trend was seen with a decrease in the prices. However, with the US economy growing stronger, combined with the boom in the Asia-Pacific region in the early 1990s the oil prices increased. Conversely, a badly timed increase in the production quota by OPEC, ignoring the economic crisis in Asia in 1997, made sure that the oil prices tumbled down to around $10 in 1999 (Sloman, 2004a).
On the other hand, between 1979 and late 1990s OPEC cut the production limits of oil several times (The Economist, 2003). History suggests that the main reasons behind it were to save the production costs and to drive the oil prices up. The law of demand states that when the price of a good rises, the quantity demanded will fall (Sloman, 2003, p.30). However, in case of oil since there are few or no substitutes, price elasticity of demand is low. Therefore the decrease in the supply with a relatively inelastic short-run demand curve for oil meant that the oil prices shot up. Illustration (a) presents the scenario on a demand and supply curve.
S1-S2: Depicts the supply cuts by OPEC. Shifting the curve to the left
P1-P2: Shows the relatively high jump in the price.
Q1-Q2: Shows the decrease in the quantity demanded which is very less
compared to the jump in the price.
D1: Depicts the short run demand curve, which is steep stressing on its relative inelasticity in short run.
In the long run though, the increasing prices lead to several reactions like new energy-efficient industrial processes, fuel efficient vehicles, etc. Coupled with the global economy going into recession, the above factors resulted in a fall in the demand, which in turn led to a decrease in prices. Thus, history suggests that demand for oil in the long run is much more elastic.
D1-D2: Shows the decrease in demand in the long run due to factors Mentioned above
P2-P3: Shows the fall in price as a result of the reduced demand in long run
DL: A line passing though points A and C gives the long run demand Curve, which is much more flat suggesting high price elasticity
The Route To $70 Per Barrel (2001-2005)
The route can be traced back to 2001 when, following the drop in crude oil prices in 1999, OPEC swung into action, announcing yet another production cut. The idea OPEC claimed was to stabilise the ever seesawing oil price and keeping it in a price band of $22-$28 (Kohl, 2005). Consequently OPEC was joined by some of the non-OPEC exporters like Oman, Norway, Russia & Mexico (Kohl, 2005). The desired price band targeted by OPEC was achieved, only to be followed by yet another dip in prices following the 9/11 terrorist attacks. Moreover, with the air traffic going down too, demand dropped once again. Another production cut by OPEC helped the prices rally (Kohl, 2005). The prices have been going up ever since.
However, the question remains, why has the oil price risen so dramatically? An article in The Economist gives a short and precise explanation that oil markets have seen an unprecedented combination of tight supply, surging demand and financial speculation (Vaitheshwaran, 2005).
Geopolitical Uncertainties Conflicts in the oil producing countries, like armed intervention in Iraq in 2003, conflicts in Nigeria and Israeli-Palestinian tension (Babusiaux D, 2004). These worked in two ways. Firstly, it caused an initial increase in demand because of bulk buying by speculators and businesses with expectations of supplies being restricted. Secondly, it actually caused supply disruption leading to an increase in prices. Increase in Demand – 2004 has seen the maximum oil consumption in the last 30 years (The Economist, 2005b). A boom in the economies of some of the Asian countries particularly China and India has dramatically increased their oil consumption. A recent article in The Economist, aptly titled oiloholics (2005b) explains that China alone accounts for one third in increase of global oil demand since 2000. In addition, the US consumption is back to normal, recovering from the 9/11 economic slowdown. Another article in The Business Week terms the phenomenon A synchronized global recovery (Reed, 2004). Demand is fast outpacing supply. This is one of the major reasons for the recent price rise.
Tight Supply – Most of the economists have blamed the tight supply on OPEC, questioning its credibility in being able to control the oil price. Some go to the extent of calling the cartel greedy (Terreson, 2005). Even though OPEC has been moving and increasing its production in response to the increasing demand, the general opinion is that its actions have not been sufficient enough to reduce the price escalation (Khol, 2005). However, the fact remains that currently non-OPEC countries are producing at their maximum capacity and only Saudi Arabia amongst the OPEC members seems to have sufficient reserve capacity. Perhaps the blame falls on inadequate investment into developing the production capacities by these countries. With supply not being able to meet the rising demand, prices wont come down in the near future.
Speculation Sloman (2004) tells us that speculators can help inject some stability in the market. However, in the case of oil markets its difficult. The markets are already boiling because of the reasons stated above and as the article in The Business Week puts it, if nothing else speculators are at least adding froth to an already heated market (Palmeri, 2004). With speculators taking into consideration specific indicators like cold winter approaching, bulk buying and stocking up oil with expectation of future price rises is an important factor.
Government policies One of the reasons why the demand is not coming down is because of subsidies given by the governments of some Asian countries like India which shield the consumers from the actual prices. Many economists criticise this policy saying that if the consumers feel the real pinch, the demand will eventually come down.
Illustration (c) shows how the price mechanism works in circumstances where the demand is increasing with tight supply.
D1-D2: Shows the tremendous boost in demand due to various factors Stated above, including speculation.
P1-P2: Shows the jump in price with supply taking time to adjust, still on S1
S1-S2: Shows increase in supply which is not enough to bring back the prices to P1
P2-P3: Shows the price adjusting to the increase in supply but settling much higher than P1.
The Katrina Effect
At the end of August 2005, hurricane Katrina hit the US coastline creating a supply disruption in an already stretched supply chain. Although the prices did go up to an intimidating figure of $70 per barrel, it did not last too long. The reason for this was the market was relatively oversupplied when Katrina hit and so the prices did not react too badly and came down to $65 per barrel soon (The Economist, 2005c). The major crunch though is in the refined product market, e.g. petrol because most of the production units affected were refining facilities. Demand for petrol is highly inelastic in the short run and hence the prices are likely to keep going skywards for some time. What Katrina has managed to do is expose, once again, a hole in the supply capacity of OPEC and other oil-producing countries.
Illustration (d) tries to depict a situation where there is supply disruption in a market with steep demand.
S1-S2: Supply disruption causes the supply curve to shift to the left
D1: A steep demand curve shows movement along the demand curve when the supply is reduced.
P1-P2: Jump in price when supply is reduced. Huge compared to Q1-Q2.
Q1-Q2: shows the change in the quantity demanded reduces only by a fraction compared to the jump in the price.
The Equilibrium price
After looking at oil in its journey from $3 per barrel in 1971 to $70 per barrel in 2005, the most striking feature is the capricious nature of the oil markets. Moreover, the situation at present is more precarious then ever. Another rather obvious point worth noting is that the equilibrium price of oil has gone up (The Economist, 27 August, 2005, p.66). According to Sloman (2003), equilibrium price is the price where the quantity demanded equals the quantity supplied – the price where there is no shortage or surplus. At present the demand is on a high and with the global economy looking quite healthy the chances of demand dropping next year are quite unlikely. Whats more, with supply being so tight it seems impossible that oil will be available at the low price band of $22 to $28 targeted by OPEC in 2001.
The Oil Finale
Armed with the knowledge of why the prices have gone up, an attempt can be made at building a scenario for the future. Analysts at Goldman Sachs predict oil prices to be around $68 per barrel next year. In light of the fact that demand looks highly unlikely to go down and new supply capacities are not going to spring up in such a short period of time, the prediction should hold true. Although OPEC has committed an increase in supply for the next year, its hardly enough to quench the thirst of the world economies. Also with the market speculating on a cold winter and high demand for 2006, the oil prices should remain between $60-$70 per barrel for the coming year.
The second part of the prediction was that oil prices will stay around $60 for the next five years. If history is a reliable guide to go by, this should hold true. The crisis in 1973 and 1980 had a sustained high crude-oil price before demand collapsed and prices came down. The major difference between then and now is the fact that the current price rise is because of increased demand and not a major supply disruption. What this means is that a demand-fired high price will be sustained over a longer period of time. This should give enough time to the oil producing countries to boost their supply capacities. However, how many investors would be interested in bearing the brunt of the expensive process of exploring new sources is questionable.
Last, but not the least, the most important and perhaps the most dangerous of all possibilities is oil crossing the $100 per barrel mark. Katrina exposed a weakness in the oil supply chain. God forbid, but if the world sees one or two even moderate supply shocks, be it another terrorist attack or a natural calamity, even $100 per barrel might look like an optimistic prediction. A recent article in The Economist puts it, There is no safety net (2005).
? Anon. 2005a. Counting the cost. The Economist. 376 (8441) 27th August. P55-56.
? Anon. 2005b.Oiloholics. The Economist. 376 (8441) 27th August. P11.
? Anon. 2003. Still holding customers over a barrel. The Economist. 369 (8347) 25th October, P61-63.
? Anon. 2005c. No safety net. The Economist. 376 (8443) 9th October. P27.
? Babusiaux, D. 2004. Oil supply and demand. Proceedings of the Panorama 2004 International Conference on Fossil Fuels: Technical, Economic and Political Issues on the horizon 2030-2050, Paris, 27th January-5th February. [Online] IFP-2002, Available on the World Wide Web: http://www.ifp.fr/IFP/en/informationcenter/ad05.htm#panorama [Accessed 24 October 2005].
? Kohl, W. 2005. The perfect storm OPEC and the world oil market. Harvard International Review. Winter 2005, p 68-72.
? Palmeri. 2004. Are the speculators driving up the oil prices? Business week. (3897) 23rd August. P49.
? Reed, Stanley, Cooper. 2004. Coping with sky-high oil prices. Business week. (3897) 23rd August. P44-49.
? Sloman, J. 2004a. Case Study 2.2 Adjusting to oil price shocks. [Online]. Pearson Education. Available from: World Wide Web: http://wps.pearsoned.co.uk/ema_uk_he_sloman_essecon_3/0,8740,1133842-, 00.html [Accessed 24 October 2005].
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? Sloman, J.2004.Essential of Economics. 3rd ed. Harlow: Prentice hall.
? Terreson, 2005.Hotting up again. The Economist. 375 (8432) 25th June. P72.
? Vaitheshwaran, V. 2005. Oil in troubled waters. The Economist. 375 Issue (8424) 30th April. P3-8.