Oil prices are now running well above $50 a barrel, partly owing to short-run supply shocks, such as the Iraq conflict, Nigerian labour disputes, the conflict between Yukos Oil and the Russian government, and Florida’s recent hurricanes.
Prices may fall once these shocks dissipate, but speculative effects could keep them relatively high, weakening the world economy and depressing stock markets.
Even a temporary spike in oil prices can have long-term effects because of the social reactions they provoke.
Experts may say that short-run supply factors caused the recent price increases, but the price increases will nonetheless lend credibility to scarier long-term stories.
The scary story that is being amplified now concerns the developing world, notably China and India, where rapid economic growth — and no restrictions on emissions under the Kyoto Protocol — are seen as creating insatiable demands for oil.
The story’s premise is that the world will run out of oil faster than we thought, as these billions of people chase their dreams of big houses and sport utility vehicles. Is this plausible?
Certainly, China, India, and some other emerging countries are developing fast. But experts find it difficult to specify the long-run implications of this for the energy market. Too many factors remain fuzzy: the rate of growth of these countries’ energy demand, discoveries of new oil reserves, developments in oil-saving technology, and the ultimate replacement of oil by other energy sources.
In spite of this, what matters for oil prices now and in the foreseeable future is the perception of the story, not the ambiguities behind it.
If there is a perception that prices will be higher in the future, then prices will tend to be higher today. That is how markets work.
If it is thought that oil prices will be higher in the future, owners of oil reserves tend to postpone exploration and expansion of production capacity, and may pump oil at below capacity. They would rather sell their oil and invest later, when prices are higher, so they restrain increases in supply. But if owners of oil reserves think prices will fall in the long run, they gain an incentive to explore for oil and expand production now in order to sell as much oil as possible before the fall. The resulting supply surge drives down prices and reinforces expectations of further declines.
All of this may seem obvious, but we tend not to think of oil prices as being determined by expectations of future prices.
For example, in January 1974, when the first world oil crisis began, oil prices doubled in just days. The immediate cause was believed to have been Israel’s stunning success in the Yom Kippur War, which led Arab oil producers to retaliate by choking off output. The second crisis, in 1979, is usually attributed to supply disruptions from the Persian Gulf following the Islamic revolution in Iran and the subsequent start of the Iran-Iraq war.
The current rise in oil prices shows that people are still eager to embrace “running out of oil” stories — this time focused on China and India —even when short-run factors are to blame. Indeed, the International Energy Agency (IEA) noted in September that the usual relationship between oil prices and inventory levels has broken down, with prices much higher than the usual relationship would suggest.
The IEA’s report calls this breakdown evidence a “structural shift in the market”. But the same pattern followed the previous two oil crises, when prices dropped from their highest peaks, but stayed quite high for years, representing a drag on the stock market, the housing market, and the world economy. Let’s hope that the effects of the present spike will be more short-lived. But don’t hold your breath. — Â