Oil: It's Supply and Demand
By all means blame high fuel prices on OPEC, geo-political uncertainty, gouging oil companies, speculators, the Government or anyone else if it makes you feel better. But don’t overlook supply and demand.
Three years ago, when oil was $US56 a barrel, I wrote an article pointing out that over 50 countries were producing less oil than they did the previous year, and that oil producing nations had started to reach natural limits on the amount of oil they could extract out of the ground to meet rising demand from China and other emerging nations.
I concluded with a call for all levels of Government to prepare contingency plans in the event oil exceeded $100 a barrel.
The only response I got to the article was from a representative of Exxon Mobil, informing me that my article "didn’t reflect the mainstream view".
The Government also continued making transport investment decisions based on a long term oil price of $US35 a barrel.
The reaction was, I think, understandable. After all, we had become accustomed to cheap oil for over 20 years and with petrol at $1.35 it was difficult to imagine prices getting much higher.
Since then, with oil prices $US100 a barrel more than Government economists predicted, I had hoped that supply and demand had indeed become the mainstream view. But it has not.
The finger of blame is being pointed everywhere but the obvious.
Speculators are singled out by many commentators as a reason for the sudden surge in oil prices. But these commentators lack an understanding of how commodity markets work. Hedging takes place when two participants more or less bet on the price of oil at a future date in time, in the same way that one might bet on the outcome of a rugby match. The placing of a bet in the oil futures market does not affect the future price that a barrel of oil changes hands between a supplier and a consumer. Only through the physical hoarding of oil could the price be affected, and there is no evidence to suggest that this is occurring.
Furthermore, a number of businesses use the oil futures market as insurance from oil price increases. Air New Zealand, for instance, has covered 83% of its current quarter consumption to a maximum of $83 a barrel, at a time when the spot price of Singapore jet fuel is about twice this amount. If it weren’t for the presence of the oil commodity market, airfares would be a lot more expensive than they are now.
Turning back to the fundamental reasons for the soaring price of oil, the number of countries that now produce less oil than the previous year has increased to 60. Even more importantly, only 44 countries managed to export more oil than they consumed in 2007. Of these, only 14 increased net exports, meaning that overall exports from oil producing countries declined by a million barrels a day.
Demand for oil, on the other hand, remains largely unaffected despite relatively high prices. In New Zealand, the Ministry of Economic Development reported fuel consumption has actually increased in the year to March 2008 by 2%. In the US, gasoline consumption is running 0.3% higher for the last month than for the same period last year. It remains to be seen if the most recent spike in prices and the removal of fuel subsidies in Asian countries will do much to curb global demand. It seems clear, though, that oil prices need to go much higher before this will happen. Only when demand is suppressed will the price of oil come down, but the rationing via price mechanism that exists for oil could shortly get very messy, especially for poorer consuming nations.
The public psyche is now moving from denial to anger, not just here but overseas as well. Civil unrest is on the rise from oil consumers who have been caught unprepared for rising fuel prices. It is therefore vitally important that we understand why oil prices are increasing and that potentially even bigger increases are likely in the future.
And, just like we have contingency plans for earthquakes and tsunamis, we still need a plan from government for the end of cheap oil.