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The record-busting price of oil, which recently broke through $140 a barrel (/b), isn’t just a crisis for many of the world’s economies—it’s also causing some market fundamentalists to question their faith.
The oil market usually adheres to the rules of supply and demand. When production slows or is interrupted, prices rise. When demand falls, so do prices. With the exceptions of the two oil shocks of 1973 and 1980, the market has been in balance—and in the long term, even those two events helped keep it that way. The recessions that followed them checked demand for oil in western economies and sent a message to producers, especially Opec: don’t beggar your customers.
With the current price shock, things look different. The world is still well supplied with crude, and production will rise steadily in the next few years. Stocks in the US, historically a good proxy for whether the market is in balance, have been in line with historical norms, and nowhere in any of the major consuming nations have there been shortages due to an absence of crude supply. Production from Nigeria and Iraq is, for obvious reasons, millions of barrels a day beneath what it could be, and output from many so-called “mature” oil provinces (like the North sea) continues to slide. Total world output slipped in 2007 by 0.2 per cent to just over 81.5m barrels a day (b/d), says BP, partly because of Opec’s decisions to restrain output, which took almost 1m b/d off the market. But those are official figures; Opec members continue to “cheat” their quotas. There are still tankers full of Iranian crude sailing round the Gulf, looking for customers.
So why have prices doubled in the space of a year despite supply remaining relatively steady? The simple reason is that people are still willing to buy oil, even at $140/b. According to the International Energy Agency (IEA), demand is still rising, albeit more slowly than forecast. This suggests that demand for oil isn’t as “elastic” as we thought.
The “elasticity” of oil demand—its responsiveness to changes in the oil price—is complicated. If you drive to work, a 30p rise in the cost of a litre of petrol (say another £12 a week) is tough—but most people in Britain aren’t yet quitting jobs that require a commute. Lorry drivers are complaining, but they will eventually pass the extra bill on to their customers. Airlines are suffering and air travel is getting pricier, but people are still flying. The world’s transport sector depends so heavily on oil products—and the global economy so heavily on the transport of goods—that switching off demand isn’t easy.
Nonetheless, things are changing. In the world’s biggest gasoline-consuming country, the US, sales of gas-guzzling SUVs are plummeting. Gasoline demand is down about 1.6 per cent since the same time last year. And now that the price of a gallon of gas has passed $4, there are predictions that demand may erode further.
All that is as it should be. But if demand from the world’s biggest oil consumer is falling and more production is expected, why are prices in the futures market still stuck at $140/b?
The answer lies in two distortions of the market. The first stems from hot money swamping the world’s commodity exchanges. Investment funds, bruised by falling stocks and a weak dollar, see oil as a hedge. In June, a near-$10/b jump in prices in one day—almost unheard of before—was triggered not by any physical shortage, but by “short-buying” the market. Investors had bet on a falling price by selling oil they didn’t own—so when news of more dollar weakness triggered a rise, they scrambled to cover their positions. According to some estimates, there are now up to three times as many “paper barrels” traded in New York and London as there are physical barrels of oil supplied to the world each day. Investment banks have jumped on the speculative bandwagon, at the same time as some of them have forecast the market; cresting as high as $200/b, in the case of Goldman Sachs. As Stephen Schork, editor of an influential oil market newsletter, says: “higher prices have become self-fulfilling prophecies.” The bull run now defies rational explanation.
The second distortion is fuel subsidies, which rob high prices of their economic impact. While drivers in Turkey, which after price liberalisation is now home to the world’s most expensive fuel, pay over $2.60 a litre (/l), their counterparts in Venezuela pay just $0.05/l. In China, the fastest-growing oil consumer, prices of about $0.60/l were roughly equivalent to those in the US last year. But US prices have since doubled, while China’s have barely risen.
This is the true inelasticity of demand, because unless consumers feel the pinch, they don’t start conserving energy, and demand doesn’t fall in response to high prices. Following the recent earthquake, Chinese demand has actually increased, says the IEA.
This angers western politicians. A recent G8 meeting of energy ministers in Japan called on world fuel subsidies to be phased out. The IMF says the same. Half of the world’s countries have subsidies, says Morgan Stanley, an investment bank, and 22 per cent of the planet’s gasoline consumption is subsidised. Some countries in the Asia Pacific region, home to the most egregious subsidies, have begun to scrap them. But China hasn’t—thus putting a floor underneath the international oil price.
China’s state-owned refiners run a loss because of these subsidies, but Beijing can afford them because its enormous trade surplus ($13.4bn in March) continues to add to its collosal foreign currency reserves (now almost $1.7 trillion). As long as the world keeps buying Chinese goods, China can keep buying oil and selling it cheaply to its citizens. A world recession, helped along by high oil prices in the west, could end that cycle. Yet removing price caps, fears Beijing, could exacerbate inflation, which is already at an 11-year high. Moreover, the Chinese advance a “moral” argument to support subsidies. Western countries got rich off cheap fuel, so why can’t China too? The answer, says the IMF, is that fuel subsidies help the better off—the ones living in air-conditioned flats and driving gas-guzzling cars—more than the poor. Better to target poverty relief in other ways.
The IMF’s stance makes macroeconomic sense. But it will be difficult to convince consumers in poor countries. A farmer in rural China is unlikely to agree that he should pay more for his fuel so the American driver can fuel up his Dodge Ram more cheaply. In Burma, violence broke out last year after the government lifted price caps. Free markets are great when they yield low prices—but cheaper oil for rich westerners could mean pricier fuel for the world’s poor.
An end to subsidies in China would send the oil speculators in New York into a selling frenzy. Until then, the investors are betting that China and other developing countries will put their citizens’ need for cheap fuel ahead of energy-thirsty westerners. Something in the market will give at some point, but it might be a question of who is beggared first: the rich west or developing Asia.
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