Factors Affecting Oil Prices in Short Term and Long Term

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 key word 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 long term rise in oil prices.
  • We experience a growth in world population.
  • Economic growth which 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 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 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.

Inelastic Supply and Price of Oil

inelastic-supply

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.

 

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