The price of Oil - affecting factors and it’s future.
Posted on March 5, 2008
Filed Under Global happenings affecting Indian Economy |
Why has the price of oil jumped five-fold in the past five years? And why has the global economy done so well despite this rise? The answers to both questions are related. The price of oil rose, in large part, due to the strength of the global economy and its impact on the demand for oil. In fact, the global economy in this decade has grown faster than at any other time in recorded history. A significant portion of this growth was attributable to the rise of China and India. Notably, both countries subsidize the cost of energy, thereby encouraging highly ineffi cient use of energy. Thus, it should be no surprise that so much of the world’s increased demand for oil came from these two countries. This is quite different from oil price spikes of the past, many of which were due to a drop in supply rather than an increase in demand.
The price of oil has also risen because the capacity to produce oil has not kept pace with rising demand. Why not? After all, a rising price should encourage producers to explore for more oil and develop new productive capacity. Yet it takes time for new investments to bear fruit. Moreover, when the price of oil started to rise earlier this decade, many producers were not convinced that the increased price would be sustained. Consequently, they were reluctant to take on new investments that might not be profitable should the price reverse. Finally, much potential new capacity exists in countries where governments, rather than private investors, decide whether to undertake new investments. In many countries, the high price has enabled governments to accumulate cash, pay off debts, and flex political muscles. New investments, which would have siphoned off much of that cash, were not considered a high priority – especially when the payoff was seen as far off in the future. The result has been very slow development of new capacity.
There are other factors influencing the price of oil. Political risk surely plays a role. An increased threat of war in an oil producing country always leads to a higher price. Political or social turmoil in an oil producing country often reduces both investment and current output. Consider Iraq, or Nigeria. Finally, the declining value of the US dollar tends to have a positive impact on the dollar price of oil. Where do we go from here? There is no easy answer to this question. The good news is that the world has collectively managed to absorb a huge price increase without much economic cost. That is partly due to the fact that, following the oil shocks of the 1970s, there was a massive investment in improved energy effi ciency. Today, the world can better absorb higher energy prices than in the past. Still, there are limits. It is probably safe to say that further substantial increases beyond the current price ($97 as of early November 2007) could be onerous, both for economic growth and inflation.
The future direction of the price of oil will be the result of several factors. First, consider demand. If the US economy slows down in 2008, the price of oil would probably fall. Second, exchange rates matter. If the US dollar continues to fall in value (which is likely), there will be pressure on the price of oil. Finally, much will depend on the political situation in several oil rich countries or their neighbors. One school of thought holds that, with the rapid growth of China and India, we’re now in an era similar to what transpired in the immediate post-war era in the 1940s and 1950s. Then, the rapid growth of the global economy spurred very rapid growth in the demand for energy – far higher, in fact, then what we’ve experienced since the late 1960s. At that time, however, oil supplies were in abundance and demand was met without high prices. It would be expected, however, that higher prices would constrain demand. Indeed, this may happen – especially in developed countries. Yet the strong economic growth in emerging countries will probably overwhelm the effect of rising prices on demand. Given today’s supply constraints we may be entering an era of relatively high oil prices.
Source: Deloitte Global Economic Outlook 2008
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