Factors affecting oil prices in short and long run

A look at the different factors affecting the price of oil in both short term and long.

Readers Question: I’m trying to update myself on what’s happening with oil prices at the moment (partly to prepare myself for uni interviews) but I’m finding very conflicting articles, such as:

  • Article warning of oil rising to $150 at BBC
  • Oil drops below $96 on Italian debt fears at Washington Post
  • Oil nears $96 on Italian debt fears at NPC

 Could you possibly explain to me what’s really going on?

It’s an interesting question, and in a way, all three articles are sound economics. It is possible to have conflicting predictions for oil prices. Perhaps the easiest explanation is to consider both short term and long term factors.

Oil Prices Since 1987

oil prices
Oil Prices – volatile

Between Jan 1999 and Jan 2008, oil price rose from under $20 a barrel to over $130. However, during this long term price rise, there were still periods where oil prices fell.

Long Term Factors Pushing Oil prices Up

The first article is primarily concerned with oil price predictions over the next few decades. It states:

Growth, prosperity and rising population will inevitably push up energy needs over the coming decades,” said IEA executive director Maria van der Hoeven. (BBC)

The keyword is ‘over next few decades’ This long term rise in oil prices could still see oil prices fall in short term due to the Euro debt crisis. But, in the long term, the price of oil is determined by ‘fundamentals’ – the long term growth in supply and demand. Long term oil prices are likely to rise if:

A shift in the developing world to car use would cause a long term rise in oil prices.
  • We experience a growth in world population.
  • Economic growth leads to increased use of oil. (demand for oil arguably has a high-income elasticity of demand, e.g. growing middle class in China can afford cars rather than bicycles, causing a bigger % increase in demand.)
  • Given the rate of economic growth in China and India, there is the potential for a very rapid increase in demand for oil – especially if we don’t find alternative energy sources.
  • Given the predicted rise in demand, it is highly unlikely supply will be able to keep pace. Oil is a finite resource, as we consume more, it will become increasingly difficult and expensive to extract oil prices.

Short Term Factors.

  • Oil is the most commonly traded commodity. The price of oil is highly volatile reflecting short term shifts in demand.
  • If the global economy, fell into a double dip recession then we would see a fall in demand for oil and therefore its price would decrease. As the articles suggest, the fear is that a Euro debt crisis could lead to a prolonged recession in not just Europe, but other countries; this would cause a significant fall in demand for oil.
  • However, when the global economy recovers, you would expect a reversal of this trend, and we would expect to see a sharp increase in demand for oil pushing prices higher.
  • OPEC has some ability to influence prices by setting output quotas. Certainly, if Saudi Arabia decided to significantly increase supply, we would expect oil prices to fall. However, the impact of OPEC has declined since the 1970s, when they were able to treble prices in a few months.

opec-cartel-oil-price-1970s The impact of OPEC cartel in 1974 was dramatic

Inelastic Supply and Price of Oil

fall-supply-oil-price-ar

In the short term, the supply of oil is relatively inelastic. It takes time to alter the supply of oil. Therefore, if there is a shift in demand, it tends to cause a relatively big shift in the price. This contributes to making oil prices more volatile.

Why might the demand for oil increase, even with higher prices?

  • Demand for oil is a normal good (it may even be income elastic). When income rises there is a bigger % increase in demand for oil. This is because:
    • Oil/petrol is a necessity for transport. Thus with economic growth, demand for petrol rises. High economic growth usually pushes up the price of oil, but, people are willing to pay the higher prices because of the economic growth.
    • During 2008, the price of oil fell because of the slump in demand.
    • There is a both an income and price effect for oil. If real incomes remained constant, higher prices would reduce demand, but, generally real incomes rise at the same time.
    • Higher price will ceteris paribus reduce demand. But, the reduced demand from higher prices may be outweighed by rising incomes. This can be applied to many other goods as well.

 

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