EconSouth (Fourth Quarter 2004)

Eduardo J.J. Ganapolsky is a research economist and assistant policy adviser in the regional section of the Atlanta Fed’s research department.


The Economics
of Oil Prices


As I start to write this column, I am feeling worried. My computer and office lights are on, and today is cold in Atlanta, so the heat is on. You might wonder why I note these facts when I am writing about oil. Well, the need for oil is everywhere. Because I am consuming more electricity, the power company needs more oil to increase production. Therefore, I am helping to keep demand for oil high.

Actually, I am not that powerful, but markets work more or less in that way: Increasing demand without a comparable increase in supply invariably results in higher prices, such as those the world is experiencing now for oil.

A bit of history
The United States’ experience with dramatic increases in oil prices has been driven mainly by supply factor disruptions: the oil embargo in the ’70s, the Iran-Iraq War in the ’80s, the Persian Gulf War in 1990–91, and again this year because of political turmoil and natural hardship in oil-producing areas. In nominal terms, oil prices marked their highest level this year when a barrel of crude reached $56.17 on Oct. 22. However, after adjusting for inflation, current prices are lower than they were during the first half of the ’80s or even the Gulf War.

Nevertheless, determining the impact of an oil shock on the economy requires taking into account not only the magnitude of the price increase, which is considerable, but other questions (and answers) as well:

  • Is the shock driven by supply or demand? The current spike in oil prices seems to be mostly demand driven.
  • How important is oil to the U.S. economy? Oil is less important now than it was during the ’80s.
  • What is the government’s policy response to the shock? Today, economists have a better understanding of the transmission mechanisms, and policymakers are better equipped to deal with these shocks than they were in the past.

Factors driving the oil market
Both supply and demand for oil have grown since the ’80s although supply has been more volatile than demand. World supply has increased at an average rate of 0.9 percent per year, with demand growing slightly faster, at 1 percent per year. These figures illustrate the trend toward a tightening oil market given that supply has not kept up with demand.

To understand the volatility of supply, it is important to recognize that most of the world’s oil supply is highly concentrated in OPEC countries and countries that were formerly part of the Soviet Union. Thus, the bulk of production—around 53 percent—comes from areas with significant political and institutional uncertainty. Oil concentration is even more pronounced if we consider proven oil reserves: OPEC accounts for 77 percent of the world’s total.

In analyzing how supply responds to demand in the short run, we must take into account the spare production capacity and the level of available inventories. Presently less than 1 percent of spare production capacity exists worldwide—a historical low. Oil inventories have been recovering since the last quarter of 2003 among members of the Organisation for Economic Co-operation and Development (OECD), a group of 30 countries committed to market economies. These stocks are in the middle range of their five-year year holdings, representing 82 days of oil consumption. Capacity and inventories point toward a very inelastic short-run oil supply; therefore, oil prices will be very responsive to any change in demand.

Peering into the future
The long-run outlook is not as worrisome. Growth in proven reserves has remained stable over the past 16 years, with around 41 years of future production available. Still, the composition of reserves might be an issue because they are highly concentrated in areas that are both politically and economically unstable. In the more stable OECD countries, areas with low extraction costs are largely becoming exhausted given current extraction technology.

On the demand side, consumption is also highly concentrated; almost 60 percent of oil is consumed by OECD countries. But this pattern is changing over time. Global growth drives oil consumption, so oil intensity—the ratio of a country’s oil consumption to its gross domestic product—is a vital factor to consider when thinking about the evolution of oil demand. Two opposing forces play a role. Oil intensity has been falling all over the world in recent decades (believe it or not, even after the arrival of thirsty SUVs). Across countries, though, non-OECD countries are much more oil intensive than OECD members are, and in the coming years these non-OECD countries will drive the world’s economic growth. Thus, we should expect a sustained growth in oil demand.

How about shifting toward substitutes for petroleum? The coal and natural gas markets are currently quite tight as well. But, from a long-run perspective, proven reserves of these fuel sources are much higher than they are for oil—60 years of natural gas reserves and 200 years of coal reserves worldwide.

Say goodbye to cheap oil
Short-run demand and supply are very inelastic, so we should expect the price of oil to be highly volatile in the near term. In the longer run, upward pressure on prices could persist because of underlying demand pressures. But, eventually, market forces should act to stimulate supply. That said, the days of cheap oil are probably gone, however.

Obviously, the impact of higher oil prices will be different across the world: Oil-exporting countries will gain at the expense of oil-importing countries, especially the fast-growing, oil-intensive Asian economies (for instance, China, India, the Philippines, and Thailand). The United States is also an oil-importing country, and this fact makes further reduction of U.S. oil intensity a priority.

For my part, I’m turning off my computer and going to the gym (on my bike, of course).

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