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The Rise in the Price of Oil

05-29 14:59 Caijing

Oil prices are rocketing up, but price predictions of US$200 per barrel are unfounded.

By Gary Becker

The run-up in the world price of oil during the past several years, and especially the rapid climb during the last few weeks to over US$120 per barrel, has fueled predictions that the price will reach US$200 a barrel in the rather near future. Such predictions are not based on much analysis, and mainly just extrapolate this sharp upward trend in oil prices into the future. The price of oil in "real" terms (i.e., relative to general prices) will not reach US$200 in this time frame without either terrorist or other attacks that destroy major oil-producing facilities, or huge taxes on oil consumption. I try to explain why in the following.

The two previous sharp increases in the world price of oil, in 1973-4 and 1980-81, were due to supply disruptions. The first one was the result of the formation of OPEC that led to output restrictions by members of this cartel, while the later one was due to the Iran-Iraq war that curtailed petroleum production in these two countries. Although the world price of petroleum rose by a lot in all three episodes, worldwide oil production went down in the two earlier ones, while production has risen during the current price boom. The present boom in oil prices has been mainly driven by increases in demand from the rapidly growing developing nations, especially China, India and Brazil, although output growth in the US and Europe have added to world demand, and speculation on potential future price increases also contributed to the increased price of oil. To be sure, supply problems in Nigeria, Venezuela, Russia and other major oil-producing states have contributed to accelerations in the oil price increases at times during the current boom.

Note the contrast between the major causes of the current explosions in oil and food prices. Although the sharply rising prices of different commodities are often lumped together, increases in the prices of corn and other foods have in larger part come from the supply side rather than from demand. The main supply culprits in the market for foods have been the diversion of corn acreage to the production of ethanol, and the increased cost of fertilizers and chemicals used in food production due to the rise in the price of oil (see my discussion of rising food prices on April 13 and 17).

The rapid growth of world oil prices during 1973-74 and 1980-81 contributed in a significant way to the world recessions during those years. Yet even though world oil prices in real terms are now above the prices in 1981, the previous peak in oil prices, and despite the sharp run-up in prices during the past couple of years, the world economy has not (yet!) been pushed into recession. One reason for the difference is that unlike the previous episodes, the current price rises have slowed rather than eliminated the boom in world output. Another difference from the previous episodes is that the share of oil and other energy inputs in GDP is down by a lot in the developed world since 1980, especially in Japan and Europe, but also in the US.

Of course, even with energy's smaller role in the production of output, any rise in oil prices to over US$200 a barrel in the next few years would have serious disruptive effects on the world economy. To many persons who have commented on this prospect, such a high oil price seems plausible, given the expected continuation of the rapid growth in the GDP of China, India, Brazil and other major developing countries. For the evidence is rather strong that the short run response of both the supply of and the demand for oil to price increases is rather small. The small elasticity of both the supply and demand for oil explains why the moderate reductions in world oil supply during the earlier price spikes, and the moderate increase in world demand during the current price boom, produced such large increases in price.

However, the long run response to price increases of both the demand and supply for oil and other energy inputs is considerable. For example, given enough time to adjust, families react to much higher gasoline prices by purchasing cars, such as hybrids and compacts, that use less gasoline per mile driven. They also substitute trains and other public transportation for driving to work and for leisure purposes. High energy prices, and hence the opportunity for large profits, induce entrepreneurs to work more aggressively to find fuel-efficient technologies, including the use of batteries as a replacement for the internal combustion engine.

Clearly, given high enough oil prices, many ways are available to increase the supply of petroleum. Explorations for additional supplies will be extended deeper into oceans and other remote places because the high cost of extracting oil from these sources would be offset by the high energy prices. Usable petroleum is also already being extracted from oil sands and oil shale, and high and rising oil prices will speed up and extend this process. The reserves of tar sands in Canada and Venezuela are huge; indeed, Canada is getting much of its oil production from this source. Oil shale is also abundant in several places, including the United States, and while extraction of petroleum from shale is expensive and complicated, the high prices have induced some countries to start doing this.

Rising prices of oil and other energy inputs will eventually be controlled by new technologies that greatly economize on the use of these inputs. Increased supplies of oil and other energy sources that become profitable to exploit only with prolonged high prices will also push these prices back.

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