Demand for oil is inelastic, therefore the rise in price is good news for producers because they will see an increase in their revenue. Oil importers, however, will experience increased costs of purchasing oil. Because oil is the largest traded commodity, the effects are quite significant. A rising oil price can even shift economic / political power from oil importers to oil exporters.

Current Account

Higher oil prices will lead to an improvement in the current account position of oil exporters like OPEC countries. It will lead to a deterioration in the current account position of oil importers (e.g. Germany, China). Oil exporters will see an increase in foreign currency reserves which they could use to purchase foreign assets. e.g. Arabic countries, such as Saudi Arabia are an important purchaser of US securities.

Inflation

A marked rise in oil prices will contribute to a higher inflation level. This is because transport costs will rise leading to higher prices for many goods. This will be cost push inflation which is quite different to inflation caused by rising aggregate demand / excess growth.

Monetary Policy

Cost push inflation caused by rising oil prices presents a dilemma to policy makers. Higher inflation usually requires higher interest rates to keep inflation on target. But, to reduce inflation may not  be appropriate because output could be well below full employment. Arguably, in early 2008, policy makers gave too much importance to the cost push inflation and too little weight to the impending economic downturn.

Long Term Effects.

In the short term, demand for oil is inelastic. This means a rise in price only causes a small fall in demand. Demand is price inelastic because consumers need oil based products, e.g. their car only runs on petrol. However, in the long term, higher oil prices will encourage consumers to diversify consumption (e.g. buy hydrogen powered cars e.t.c.)

Also, higher oil prices will encourage firms to try and find more oil supplies, even if it is expensive, remote places like the Antarctic.

Related

• A world without Oil
• Higher oil prices and marginal consumption

Oil prices could fall if:

Supply Increases by more than expected.

For example, maybe a country like Iraq or Iran has an unexpectedly large reserve of oil that they could easily start producing. This increase in supply would cause prices to fall. Note: it is notoriously difficult to predict how much oil is available, and some do say that Iraq has a lot of untapped supply.

Market Sentiment Changes

Not all movements in the oil price is due to basic supply and demand, there is also a speculative element to the rising price of oil. People are buying oil futures and oil stocks because they expect prices to keep rising; this speculative demand is causing prices to rise by more than is justified by economic fundamentals. If people feel that oil price has peaked (at least for short term) speculative buyers will sell causing prices to fall.

Global Recession

At the moment, the main reason for rising oil prices is the increased demand for oil, particularly from countries like China and India. However, if there was a global downturn then demand would slacken off and prices could fall. A recession in just the US may not be enough; it may require a downturn in China.

Alternatives to Oil

Another factor that could cause price of oil to fall is if a realistic alternative to oil was found. For example, if hydrogen cars became cheaper than petrol cars. This might not happen overnight, but over time demand for oil could fall as people switch to alternatives. This would eventually cause prices to fall.

Despite attempts by Saudi Arabia to increase supply, the price of oil has continued to rise. The main reason for the rising price of oil is the increased demand that we are seeing, especially in the developing world. Countries such as China and India are experiencing rapid rates of economic growth. Because their population is so large ( a combined population of over 2.5billion) this rapid expansion is causing an unprecedented rise in demand for oil.

Inelastic Demand.

With many goods higher prices lead to lower demand as people switch to alternatives. However, demand for oil is notoriously inelastic because of the lack of available substitutes. In the long term, demand may become less inelastic because substitutes develop; but, at the moment we still search for those elusive alternatives.

Disappointing yields from Known suppliers

Many countries have struggled to increase supply as much as they like. US, UK, Russia and even many Arab countries have found it difficult to meet the rising demand. Their is still plentiful oil supplies (although there is a significant debate about the true extent). However, as more oil is extracted, it becomes increasingly expensive and difficult to extract oil. Certainly now that oil is over $140 a barrel it will encourage oil exploration in less accessible areas such as Siberia and the Antarctic. But, even it if is possible to increase supply from these areas, it will take time for these extra supplies to come on track.

Speculation

The price of oil does not just depend on economic fundamentals. There is also an element of speculation with investors predicting oil prices will keep rising, therefore, they are buying oil futures pushing prices up.

As oil runs out, supply will shift to the left and the price will increase. Because demand is inelastic, oil firms will make increased profits. This creates an incentive for oil companies to discover new oil supplies. This research is often expensive, so the higher profits is beneficial for encouraging investment. There are many oil reserves which are difficult to access, e.g. oil in the Antarctic and Siberia. Therefore, the cost of production may be $100 a barrel. Therefore, now oil prices have risen over $100, it has become profitable. Therefore, the market can respond to the changing market signals and try and increase supply. Also, firms have an incentive to develop and promote alternatives to oil, such as solar panel cars; the more expensive oil becomes the more attractive these options are.

In theory, the free markets should respond to shortages and rising prices through increasing supply or developing alternatives. However, the free market may not be able to deal with the oil shortages in a timely manner.

Firstly, demand is rising very rapidly because of economic expansion in Asia (China and India). Therefore, prices are rising rapidly, even though supply is still increasing. If we had a combination of falling supply and rising demand, prices could skyrocket. Investing in new supplies or alternatives to oil could take several years. By the time the free market has provided alternatives to oil, the world economy may have suffered several years of very high oil prices.

High oil prices will create the following problems.

• Increased cost of production
• Cost push inflation
• Lower living standards, especially amongst oil importers.
• A shifting economic power from oil consumers to oil producing countries.

There is market failure in developing alternatives. – Firms may be reluctant to take risks. Firms may not have sufficient funds to invest in risky innovation. Finding alternatives to oil may not be so easy. IT may take many expensive failures before suitable alternatives are found. Markets respond to crisis rather than anticipating them.

How Government Can Help.

The government can subsidise firms who are developing alternatives. The government could even initiate schemes themselves. This helps to overcome the problem of finance for risky investment. However, government subsidies may be targetted at the wrong firms, and it may be misused. But, oil is such an important commodity can we leave it to the free market?

If we do leave it to the free market, there may be several years of uncomfortably high oil prices as the market struggles to respond to the price signals. Therefore, government intervention can be justified on the grounds of overcoming market failure.

See also:

Finding alternatives to oil

• Brent Crude oil reached $126
• US light crude oil reached $128 before setting back to $127

This means that, even adjusted for inflation, oil is now close to the all time high, last reached in the 1970s.

What are the reasons behind the Recent Increase in price of oil?

• Strong Economic Growth. In particular growth from China and India have caused increased demand for oil and related products
• Shortage of Supply.
• Speculation – People have been speculating on the continued rise in price of oil. It has become an alternative to the weakening dollar.
• Political Tensions – With the lingering threat of invasion of Iran, commentators still feel that events in the middle east could disrupt future supplies and cause higher prices.

Forecasts for the Future

Speculation or Shortage?

Some members of OPEC dispute that there is a fundamental shortage of oil. They argue that there is plentiful supply of crude oil. Therefore they argue that the recent price rises are not based on economic fundamentals, but a speculative bubble. If this is the case, oil prices could easily fall next year when market sentiment changes.

Global Growth. Some feel that the US economy is heading towards recession, because of the weakness in the housing market. However, US growth is still remarkably resilient and Global growth is being bolstered by the strong performances from the Chinese and Indian economy. With no imminent slowdown in economic growth from China, demand for oil is likely to keep rising.

The Dollar. If the dollar continues to remain weak, this will strengthen oil prices. Yesterday, the Fed said interest rates are unlikely to fall in the near future; this may help stabilise the dollar. See predictions for US dollar 2008

Related:

• Economic effects of a post oil world
• Should we be concerned with running out of oil?
  
• Reasons for fall in US Dollar
• Has OPEC misused its power

It is difficult to say.

Firstly on the demand side, demand for oil is rising faster than many expected. This is largely being driven by rising growth in developing economies such as India and China. Today we consume an average of 85 million barrels daily. According to the most conservative estimates from the International Energy Agency that figure will rise to 113 million barrels by 2030.

On the supply side the known reserves of oil varies between 1 trillion barrels and 3 trillion.

Unknown Reserves

The amount of oil reserves is uncertain. For example, there could be a lot in the Antarctic. At the moment, this continent is relatively unknown. However, as oil prices rise, it will become difficult for countries to resist the the temptation to increase supply in these fragile areas.

Steady Decline of Oil.

Most oil analysts argue that the production of oil tends to follow a bell curve distribution. Reaching a peak before slowly declining and tailing off towards the end.

Will the Market Provide an Alternative?

The other issue with oil running out is that market forces may encourage alternatives. As supply falls and demand continues to rise, the price of oil will increase. As the price of oil increases, people increasingly find alternatives to oil. With oil at $100 a barrel, it is still economical to use oil, but, if the price of oil doubled to $200 it may become economical to use alternative energy sources such as solar panels, natural gas. Therefore, it may be that the supply of oil never runs out, there will simply come a point when no one wants to use oil any more.

The Tipping Point.

An important point will come when the amount of oil reserves is less than the total amount of oil consumed. After this point is reached, prices of oil will rise sharply. The rising prices may encourage new oil exploration, but, there will come a point when it is more economical to develop alternatives.

World Oil Supplies set to run out soon.

Should we be concerned about running out of oil? 

Oil price predictions 

Oil price predictions

OPEC comprise over 50% of the world’s oil suppliers. Therefore, if they restrict supply of oil it will have a significant impact on increasing price. (Diagram will be a simple supply and demand, with supply shifting to the left. Don’t forget demand for oil is quite inelastic, so a fall in supply has a big effect on price. Note this diagram shows an elastic demand, but for oil it should be steeper and more inelastic

Graph of Fall in Supply of Oil

Therefore, if prices are falling below their target they will try to set quotes and restrict supply.

Recent OPEC activity.

• I believe the recent rise in the price of oil is not really due to OPEC it is due to:
• Increased Demand (especially from China)
• Falling Supply in Iraq
• Falling Supply in non OPEC countries.
• Speculation about future of Iran and Middle east politics
• The fall in the dollar. Note – measure in Yen, the fall in the price of oil is much less severe. The oil price’s fall is exaggerated because of the weakness of the dollar

What Happens if Oil Prices Continue to Rise?

• There is an increased incentive to increase supply in areas where it is more expensive to extract oil. E.g. antarctic. – could even cause friction as countries race for the right to extract from remote areas.
• Increases the attractiveness of alternative fuels such as bio fuels and solar panels.
• Increases Demand for alternative forms of cycling (well maybe pretty insignificant)
• Depends on whether rise is short term or long term.
• OPEC may not want price to rise too much because it will lead to higher supply in non opec countries.

When a war breaks out in the middle east, there is likely to be disruption to the supply of oil. 50% of our oil comes from the middle east, so if the countries are engaged in war then output is likely to fall and supply shift to the left causing price to rise.

Even if output doesn’t fall, people may push the price of oil higher because they think that it might do. There is also a fear that middle eastern countries may restrict the supply of oil just to annoy Western countries like the US. This happened in the 1970s.

The supply would shift from s2 to s1. The price would rise from P2 to P1

If oil and petrol are more expensive then people will look for alternative forms of transport. For example, rather than buy a car people may continue to buy bus tickets and cycle to work. If the price of oil is cheaper then people will want to buy second hand cars like a Ford falcon. Therefore, there will be less demand for ford falcons and the price will fall.

Last year, Shell made profits of $27.6bn (£14bn). This equates to profits of about £1.5 million per hour – which by any stretch of the imagination is not a bad hourly earning.

The profits have been criticised by trades unions, environmentalists and motoring organisations.

Motoring organisations claim that petrol is too expensive and it is unfair companies make such profit at the expense of the motorist. Personally, I think petrol should be expensive (for environmental reasons). But, also, Shell make the majority of their profits in the production of upstream oil, not at the petrol pump. The profit margin on the retail price of petrol is quite low; most of the cost of petrol is tax to the government.

Environmentalists argue it is wrong to make the profit from a process which is contributing to environmental problems. It is argued a windfall tax should be levied on  the profits of Shell; this money could be used to combat the effects of global warming.

Jeroen van der Veer, Shell’s chief executive replied to these criticisms by arguing:

“A windfall tax against the oil industry called for by the unions and the environment group Friends of the Earth would be counter-productive: “Any additional tax – if significant – [means] we can invest less and over time it will impact on our production,”

Should Companies be Taxed More?

Yes

1. They operate in an oligopoly, most of Shell’s profit comes from having monopoly power in the production of oil
2. They don’t need £14 billion a year for investment. Majority of profit goes to shareholders

No

1. Profit is a reward for the nature of the business.
2. They can use profits to develop alternatives to petrol (although whether they are serious in this is a good question)
3. Shell already pay corporation tax

What do you think? Should the Government place a windfall tax on Shell ?

Oil price predictions 2008 

Top 10 British Companies