Oil Prices in Recent Years,

Oil Prices In recent years, the price of oil has become increasingly unstable. 2008 in particular saw a huge run-up in oil prices, followed by a sharp decline. While price movements this year have not been as dramatic, there is still significant volatility in the market. There are a number of competing theories with respect to why oil prices have become so volatile. There is some concern that speculation has driven the market to a greater extent in recent years, although this cannot be conclusively proven.

Others suggest that supply and demand factors are more important. We are past peak oil, after all, and the price elasticity of demand has decreased significantly in recent years. This paper will analyze the recent volatility in oil prices in the context of supply and demand, and will examine the potential impacts not only of speculation on oil prices, but of higher oil prices on the overall economy. Demand In the past couple of years, there has been a surge in demand for oil.

This owes to a couple of factors. The first is increasing demand in developing economies. In particular, China and India have been singled out for their increasing demand. China's demand for crude oil increased 5.8% in 2008. The rate of growth in demand is also accelerating, having been 4.3% the year previous (Xinhua, 2009). In India, demand has also increased, as that country's GDP expands at 9-10% annually (Zaidi, 2008). OPEC estimates show that demand from OECD countries is expected to flatline, with global growth in oil demand coming almost entirely from developing nations (Hamel, 2009).

It is worth noting, however, that while growth in demand has been spurred by emerging economies, the highest level of demand still comes from North America, Japan and Europe. The country that consumes the most oil is the United States. The main demand drivers for U.S. oil consumption are transportation and industry. Transportation amounts to 27.8% of U.S. energy consumption, 95% of which comes from petroleum. Industrial usage accounts for 20.6% of total energy consumption, 42% of which comes from petroleum (Energy Information Administration, 2009).

The United States is therefore highly dependent on petroleum for economic function. This has lead in recent years to a sharp reduction in the price elasticity for oil. Hamilton (2008) noted that short-run elasticities for crude oil to be -0.1 and the long-run elasticity of demand for crude oil to be between -0.2 and -.0.3. Hughes et al. (2008) found that short-term elasticities for the price of gasoline declined significantly between the late 1970s and the early 2000s (Appendix A).

The price of crude oil accounts for roughly 50% of the price of gasoline (EIA, 2009), so a general correlation in elasticities can be drawn. Thus, we see that first of all global demand for crude oil has increased, largely as a consequence of rapid economic growth and increases in private automobile ownership in developing nations, in particular India and China. This is combined with the fact that American consumers -- the world's largest single group of crude oil consumers -- have lost their price elasticity.

That creates an environment were rising prices are not met with a corresponding decline in demand. Thus, prices can be allowed to rise more rapidly and more substantially than in past eras. Supply The supply of oil is roughly controlled by the Organization of Petroleum Exporting Countries (OPEC). OPEC members only account for roughly one-third of global oil production. However, the remaining oil-producing nations are not organized.

As a result, OPEC controls the supply of oil in the world by establishing its production levels, taking into consideration expectations for demand and non-OPEC supply. The result of this is that OPEC essentially sets the benchmark crude price, which is the derived from the cost of oil that its members produce (Daya, 2009). To derive its expectations of future demand, OPEC takes into account many factors, including its expectations for the global economy.

OPEC's models account for economic expectations and the expected impact that these will have on oil demand, in particular from the world's key consumers. OPEC attempts to set the oil price at a level that will allow its members to carefully manage production and profits. Thus, they do not seek to flood the market to reduce the price, nor do they seek to squeeze supply. Non-OPEC producers are driven by different sets of motivations. Some nations produce for domestic use rather than for trade.

Other nations produce for trade, but prefer to manage their own output, away from the directives of OPEC. These nations, however, have little influence over the price of crude, which remains set essentially by the cartel. One caveat to this, however, is that OPEC has no enforcement mechanisms, and therefore its members will occasionally overproduce, throwing the expected supply out of alignment (Williams, 2007). This situation, however, can generally only cause temporary and minor shocks.

Excess capacity in Saudi Arabia allows that country to strategically control OPEC reserves even when other members overproduce on their quotas. Speculation It is widely believed that the high volatility in crude prices, particularly in 2008, is not simply a function of supply and demand. Demand in developing nations may have increased, but many feel that this increase was not a sufficiently significant shock to cause such a huge spike and subsequent crash in crude prices.

There is reason to believe that the newfound volatility in crude oil prices stems from speculative behavior. Oil is traded on the New York Mercantile Exchange and traditionally the companies trading in oil were those that used it in their businesses -- airlines, fuel companies. Positions in oil have become increasingly held by investment entities seeking to speculate on the price of oil, such as CalPERS, the Harvard Endowment and other institutional investors (Kroft, 2009).

Using leverage and substantial financial capability, these speculators were able to create a bull run in oil in 2008. The evidence is considerable. In 2008 there were 27 barrels of oil traded for every 1 that was consumed. The amount of institutional money in the commodities markets shot up from $13 billion to $300 billion in just five years. Speculative investing represents a significant distortion in the market for oil. Because the traders have no need of taking delivery, they are merely concerned with spreads and percentages, rather than actual prices.

These entities engage in substantial buying and selling, yet they represent neither demand nor supply. Indeed, supply rose and demand fell during the period when crude oil prices spiked, illustrating that speculation was the main price driver, not supply and demand. This distortion is the only reasonable explanation for the stark divergence between supply, demand and price in 2008.

Graph 1 shows this disconnect, as crude supply and crude demand changed little during the period of high volatility, which should not have been the case -- such volatility in price should have accompanied by an equivalent disconnect between supply and demand. Cost of High Oil Prices No matter from where high oil prices derive, they have a considerable impact on the economy. We have seen that in the short-run, there is little elasticity of demand.

However, that study did not take into account 2008, when the price more than doubled in just a few months. With crude at $140 and gasoline prices in the U.S. over $4 per gallon, it is reasonable to expect that elasticity would have increased. Typically, higher prices will cause a decrease in economic activity. Consumers will take steps to drive less. They will begin to purchase smaller vehicles, which cost less and have lower margins.

Because of the low degree of elasticity, however, the main impact will be a reduction in consumer dollars for other goods and services. Thus, the impact will be spread across the economy, with discretionary spending the first to decrease. Additionally, businesses will take steps to reduce spending so that they, too, can afford their higher oil costs. These actions will lead to a decrease in economic activity.

It is difficult to separate the decline attributed to high oil prices from the general economic meltdown last year, but higher oil prices were a contributing factor. Some sectors, however, benefit from high oil prices. In particular, competing energy sectors will benefit as consumers, businesses and entrepreneurs alike work to find lower-cost energy alternatives. Additionally, producers of high-cost oil such as Canada are able to bring more of their oil to market profitably, so that high oil prices encourage further oil development in some areas.

Past History There is little in the history of oil prices that can compare with the run-up of 2008. On September 22nd of that year the price of crude jumped $25 in a single day, by far the most in history (Ibid). However, there have been price shocks in the past. The first major oil price shock was in the early 1970s, when OPEC nations enacted an embargo as a result of the Yom Kippur War. The price of crude went from below $20 to over $40 (2005 dollars).

This was the clear result of a tightening in supply, however. Another major fuel price shock occurred as a result of the Iranian Revolution and the subsequent Iran/Iraq War. This again caused a supply shock as two of the world's major oil producing nations were completely destabilized (Williams, 2007). In the 2000s, a number of factors have combined to drive up oil prices. Major economic gains in key, highly-populated developing markets have served to increase demand substantially.

The Iraq War has destabilized that nation's oil supply and the Mideast region in general. A weaker U.S. dollar, another consequence of the Iraq War, has also caused the price of oil -- traded in U.S. dollars -- to rise (Ibid). These events correspond with traditional supply and demand drivers. The events of 2008 may have been the result of speculation, but over the course of the past decade, it is more likely that supply and demand are responsible for the run-up in fuel prices.

Conclusion There are three main drivers to crude oil prices -- supply, demand and speculation. The former are traditional drivers, and can be clearly identified in the context of previous shocks to the price of crude oil. What supply and demand cannot explain, however, is the price of crude oil in 2008. Supply was increasing, demand was falling and yet the price of crude skyrocketed to unheard of levels. This abnormal behavior was the work of speculation in the marketplace.

Speculators, by virtue of not actually using oil, only care about spreads, not about prices, which in concert with leveraged trading allows them to drive prices to levels not normally considered tenable. There are normal supply and demand factors at work as well. Crude oil prices have increase significantly over the past.