Galloping Oil Prices: Supply-Demand Dynamics

“Crude oil prices have become detached from the dynamics of supply and
demand”1

- HE Abdalla Salem El-Badri, Secretary General, OPEC

If there is one commodity that has the power to propel the global economy
forward or bring it to a grinding halt, it is crude oil. Crude oil, rightly dubbed
as ‘black gold’, plays a vital role in the production and distribution of a large
number of products that are being used everyday either directly or indirectly.
Its use is indispensable in transportation. It impacts the prices of fruits,
vegetables and other food items because of the transportation cost involved
in moving them from one place to another. It is used as energy input for
heating domestic and industrial buildings and as lubricant for engines and
machines. Viewed as a source of energy, the percentage share of oil in the
total world energy mix was about 36.4%2 in the year 2005.

Apart from its all-encompassing use, the importance of oil stems from the
fact that oil is a non-renewable finite resource. The absence of an affordable
alternative source of energy makes oil a highly volatile commodity in the
world market. Fluctuations in the demand, supply and price of oil can have
far-reaching consequences on the functioning of the global economy. The
price of oil indirectly determines the price of almost every other commodity.
The price of oil has been rising steeply since 2003 and it reached a high of
$147 per barrel in July 20083. The rise has brought into focus the factors that
contribute to an increase/decrease in the price of oil. It has been argued that
unlike other commodities, the pricing of oil does not always comply with the
laws of demand and supply. A complex combination of macro-economic, geo-
political and environmental factors plays a crucial role in determination of the
price of oil.

Oil Crisis: Supply-Demand Dynamics

The largest markets for crude oil are situated in London, New York and
Singapore. But crude oil and its by-products are traded all over the world. The
quality of crude oil is determined on the basis of its specific gravity and
sulphur content which in turn depends on the place from where it has been
extracted. The density of the crude will decide the level of processing
required to refine it. Crude oil with less density and lesser sulphur content
will require a simple distillation whereas heavier crude with higher sulphur
content will require additional processing to produce the end product. The
1
Laird Kerry, “OPEC: Oil Market 'Detached' from Supply and Demand”,
http://www.rigzone.com/NEWS/article.asp?a_id=60651, April 21st 2008
2
Hussain Ali, “Security Of Oil Supply And Demand And The Importance Of The
“Producer-Consumer” Dialogue”,
http://www.mees.com/postedarticles/oped/v49n50-5OD01.htm, December 11th 2006
3
“Price of oil spikes to almost $147 and then drops”,
http://www.iht.com/articles/2008/07/11/business/11oil.php, July11th2008

1
difference in the cost of processing various types of crude oil will have an
impact on the price of the end product. Apart from the cost of processing,
factors such as the cost of transportation of crude oil from the producing field
to the refinery and from the refinery to the consuming market, cost of storage
and distribution, market conditions, etc also play a vital role in arriving at the
final price of petroleum products.

As there are too many varieties and grades of crude oil, the benchmark or
marker crude system was introduced in the mid-1980s for the sake of
convenience in trading and pricing of crude oil in the international market.
The price of the benchmark crude oil is taken as the baseline price on the
basis of which the price of other varieties is fixed according to their quality in
relation to the benchmark. Dubai crude is used as the benchmark in the gulf
region. West Texas Intermediate (WTI) is the benchmark used in the United
States. The New York Mercantile Exchange quotes the price of light, sweet
crude oil which has a sulphur content of less than 0.5%. If the sulphur content
is more than 0.5%, the oil is said to be sour. Another popular benchmark is
the OPEC basket price which takes into account the average of 15 different
crudes from member countries which include the Saharan Blend from Algeria,
Girassol from Angola, Oriente from Ecuador, Minas from Indonesia, Iran
Heavy, Basra Light from Iraq, Kuwait Export, Es Sider from Libya, Bonny Light
from Nigeria, Qatar Marine, Saudi Arabia's Arab Light, Murban from the
Emirates and BCF 17 from Venezuela. Brent blend crude oil from the North
Sea sold at London's International Petroleum Exchange is generally accepted
to be the world benchmark. Although there are different benchmarks, the
price difference among them is very minimal and the price of crude oil is
more or less the same in all the markets4.

Like any other commodity, oil is also prone to frequent price fluctuations.
Because of certain unique characteristics of the oil market, it is difficult to
ascertain the actual cause of such fluctuations at any given point of time. The
recent upsurge in world oil prices has set in motion a hot debate over
whether or not the price hike is the result of a mis-match between supply and
demand conditions. Some Economists are steadfast in their view that the
recent swell in oil prices is indeed the result of the existence of a gap
between supply and demand factors. According to them, when the price of oil
reaches a point which the market will no longer be able to bear, demand will
automatically come down. This in turn will bring down the price paving way
for equilibrium in the market. Oil market experts, on the other hand, claim
that the disparity between theory and practice is too wide in the case of oil
and hence oil is an exception to the rule and does not always obey the laws
of demand and supply. The pages of history are replete with instances that
support their contention.

Formation of OPEC: Before 1960, the production and distribution of oil in

the world market was largely controlled by the ‘Seven Sisters’. Seven Sisters
is a term coined by the Italian oil magnate Enrico Mattei to refer to the seven
international oil companies comprising of Standard Oil of New Jersey, Royal
4
“Oil markets explained”, http://news.bbc.co.uk/2/hi/business/904748.stm, October
18th 2007

2
Dutch Shell, Anglo Persian Oil Company, Standard Oil of New York, Standard
Oil of California, Gulf Oil and Texaco who dominated the world oil market5.
The developing countries who were the owners of the oil reserves had very
little say in the affairs of business. The Seven Sisters decided the rate of
return that could be enjoyed by these countries. In order to protect their
interests and assert their position as owners, five oil producing countries
namely, Iran, Iraq, Kuwait, Saudi Arabia and Venezuela came together to form
the “Organisation of Petroleum Exporting Countries” (OPEC) in the year
19606. OPEC was created with the objective of achieving price stability in the
oil market by adjusting output according to market requirement and at the
same time ensuring that the oil producing countries get a fair rate of return
for their investment. Other oil producing nations joined OPEC as members in
subsequent years (Exhibit I).

Exhibit I
Members of the Organisation of Petroleum Exporting Countries

Country Joined OPEC Location

Algeria 1969 Africa
Angola 2007 Africa
Ecuador(**) rejoined 2007 South America
Indonesia 1962 Asia
IR Iran* 1960 Middle East
Iraq* 1960 Middle East
Kuwait* 1960 Middle East
SP Libyan AJ 1962 Africa
Nigeria 1971 Africa
Qatar 1961 Middle East
Saudi Arabia* 1960 Middle East
United Arab Emirates 1967 Middle East
Venezuela* 1960 South America
*founder Members
** Ecuador joined OPEC in 1973, suspended its membership from Dec. 1992-
Oct. 2007
Source: “Who are OPEC Member Countries?”,
http://www.opec.org/library/FAQs/aboutOPEC/q3.htm

Arab Oil Embargo: When the Second World War came to an end, the Allied
forces created ‘Israel’ from out of the British-controlled territory of Palestine.
The purpose was to provide a homeland to the millions of homeless Jews
5
Nicholas Vardy A., “The New Seven Sisters: The World's Most Powerful Oil
Companies”, http://www.theglobalguru.com/article.php?id=110&offer=GURU001
6
“Brief History, The Organization of the Petroleum Exporting Countries (OPEC)”,
http://www.opec.org/aboutus/history/history.htm

3
across the world. The local Arabs were hostile to such a settlement and
stubbornly refused to acknowledge Israel as an independent country. There
was constant strife between the two nations which culminated into a full-
fledged war in 1973. The then Soviet Union extended technological support
to the Arab forces. Israel was helped by the United States of America and
other western countries. This infuriated the oil rich Middle Eastern Countries
who collectively imposed an ‘oil embargo’ to halt oil exports to western
countries as punishment for supporting Israel. The embargo sent oil prices
spiraling upwards to dramatic heights. It had a cascading effect on the prices
of almost every other product that needed oil either directly or indirectly. It
sent shockwaves through the western nations who were the major consumers
of oil during that period. The reaction of the western countries, especially the
United States of America to the oil price shock made the Middle Eastern
Countries realize that they could wield significant power over other nations
by using oil as a political and economic weapon. By the time the embargo
ended a year after it was imposed in 1973, the price of oil had quadrupled in
the west.7 Even after resuming shipments, the Arab Countries managed to
maintain the high prices and earned huge profits. The Iranian Revolution and
the subsequent invasion of Iran by Iraq in 1980 propelled the oil prices to
escalate from $14 in 1978 to $35 per barrel in 1981. There was a significant
increase in the price of crude oil in 1990 when Iraq invaded Kuwait. During
the ensuing Gulf War to liberate Kuwait which started on January 16th 1991,
there was a gradual decline in the price of crude oil8. In 1994, the inflation
adjusted price of crude oil reached its lowest level since the days of 1973
when the oil embargo was in operation9.

Some analysts have made an interesting observation from the study of

movement of oil prices. In all the above instances, interruptions in supply
were not significant enough to cause a steep rise in prices. Yet prices rose to
alarming levels due to panic in the minds of oil producers, oil companies and
consumers. Hence more than the actual supply and demand for oil, it is the
people’s perception about the availability and requirement for oil that
determines the price. This is because, unlike other commodities, oil statistics
suffer from lack of reliable information Theories about Peak Oil are
multiplying by the day and nobody is sure about the quantity of oil that is still
left under the ground. No accurate information is available regarding the
quantity of oil that has been pumped out so far or the quantity of oil that has
been consumed over a period of time. Most of the oil companies are
reluctant to disclose the information about their levels of production and
there is absolutely no transparency in the stock-data10 of various countries.
This absence of dependable data is the foundation of fluctuations in oil
prices.

7
Horton Sarah, “The 1973 Oil Crisis”,
http://www.ccds.charlotte.nc.us/History/MidEast/04/horton/horton.htm
8
“The Persian Gulf War (Jan. 16, 1991–April 6, 1991)”,
http://www.infoplease.com/ipa/A0001293.html
9
“Oil Price History and Analysis”, http://www.wtrg.com/prices.htm
10
Stock data refers to the quantity of oil produced by a country and the quantity
stored as reserves at a given point of time

4
The oligopolistic nature of the oil market is another factor that caused an
upward shift in prices. Although oil is used by the entire population of the
world in some form or the other, its availability and production are
concentrated only in a few regions (Exhibit II).

Exhibit II
World's Top 10 Crude Oil Reserve Holders

Source: “How World Oil Markets Work”,

http://fuelfocus.nrcan.gc.ca/fact_sheets/oilmarket_e.cfm

The limited location of oil reserves on the earth’s surface and its unlimited
usage gives rise to a permanent sense of apprehension in the minds of
people as to its availability in sufficient quantities to meet the ever increasing
demand. Ever since its inception, OPEC has been playing a crucial role in
bringing about a balance between demand and supply, by adjusting
production. But of late, it is observed that its hold on crude prices has been
waning and by its own admission, oil prices are no longer controlled
exclusively by demand for and supply of oil.

Oil prices are extremely inelastic in the short run. This is another reason for
volatility in oil prices. A very steep increase in the price of oil will result in a
very trivial fall in demand because oil has become an integral part of
everyday life and it is not possible for people to change their lifestyle
overnight. Cross elasticity of demand is also nil in the case of oil as there is
no affordable substitute for it. The supply side of the equation is equally
unresponsive in the short run. Even if the price is high enough to lure

5
producing nations, supply cannot be increased immediately. The time
consuming process of exploration, drilling, production and refining means
that it will take a long time for oil to reach the market to meet the spurt in
demand. Similarly when there is a sharp decline in the price of oil, demand
will not rise dramatically due to storage considerations on the part of
consumers. The producers too cannot withdraw supply suddenly once the
production process has been set in motion.

Since the oil market trading is based more on perceptions than on economic
fundamentals, many oil producers are reluctant to increase production
beyond a certain level even though prices are hitting the roof. If the
perceived fear of shortage of oil turns into one of hope of over-supply, the
sudden surge in demand will immediately fade. For example, if a rumor is
spread that supply from a particular country will be disrupted due to political
tensions, people start panicking and demand more oil than they actually
need, thereby pushing up the price. As soon as it is proved that the report is
false, people will immediately stop demanding extra oil, leading to a fall in
price. If the producers had invested more in expanding capacity lured by the
initial hike in price, they will not be able to interrupt the production process
after the decline in price and there will be a glut of oil in the market. The
price will drop drastically and the Oil producing nations will suffer huge
losses. Most of the oil producers in the world are developing countries. They
are very vulnerable to oil prices because oil is the single biggest source of
revenue for them. In some of these countries, oil exports account for more
than 90% of total exports11. Their economies were severely hit when the price
of oil plummeted to rock bottom levels in 1998. Naturally they exercise
caution in confirming that the demand is economic growth-driven and not
market psychology-driven whenever they are expected to increase their
output to offset the acceleration in price. This is exactly what has been
happening in the oil market scenario in recent times.

The price of oil has increased more than five-fold since 2000 (Exhibit III). It
reached a high of over $147 per barrel in July 2008 and hovers around $120
per barrel as of August 200812. Although a decline in the price is observed,
the International Energy Agency (IEA) has warned that it is too early to
conclude that the market has come out of the price shock and has stressed
that the downturn can be sustained only when ‘all other things remain equal’.
By ‘all other things’, the IEA refers to factors such as the speculative activity
of traders, geo political tensions, level of global economic activity, climatic
changes, etc.

Exhibit III
Oil price rise since 2000

11
“Security of Oil Supply And Demand and the Importance of the “Producer-
Consumer” Dialogue”, Op.cit.
12
“Supply concerns send oil surging”,
http://news.bbc.co.uk/2/hi/business/7574409.stm

6
Source: “Oil price up despite Saudi pledge”,
http://news.bbc.co.uk/2/hi/business/7468555.stm#graphic

It was strongly felt that the demand for oil was growing at a very rapid rate
from emerging markets such as China and India, but supply was not keeping
pace with the demand. Consequently the price of oil mounted to unjustified
levels. Despite tremendous pressure from various quarters to increase
production, the Organisation of Petroleum Exporting Countries firmly
maintained that there is abundant supply of oil in the market to meet the
demand and held speculation in the industry was responsible for the jump in
prices.

The supporters of OPEC’s viewpoint quote statistics to prove their point. In

the year 2007, the total oil consumed by China increased by an additional
377,000 barrels per day but that of Germany and Japan decreased by
380,000 barrels per day thereby nullifying the net effect of China’s increased
consumption13. During the first quarter of 2008, total oil production grew by
2.5% more on yoy basis. But the corresponding increase in world oil
consumption was only 2%. Production is estimated to grow by 3.3% and 4.1%
respectively during the second and third quarters although the concurrent
growth in demand is projected to be only 1.6%. The United States of America,
the largest consumer of crude oil in the world is reported to have consumed
4% less petroleum during January 2008 on yoy basis. It has also been
observed that this drop in demand happened before the price of oil climbed
to unprecedented levels and before the US economy showed any ostensible
sign of recession. China’s demand for oil which was growing at a rate of 10%
per year has also come down to 6% per year. Moreover, world surplus oil
production capacity has doubled from a mere 1.5 million barrels per day to
over 3 million barrels per day. Going by these data, it can be said that the oil
market finds itself in a paradoxical situation where supply is more, relative
demand is less, yet the prices have skyrocketed which defies the basic
principles of Economics14.

13
“Q&A: Oil prices and the economy”,
http://english.aljazeera.net/business/2008/07/200879184520258575.html
14
Bailey Ronald, “Oil Price Bubble? Supply is up, demand is down, yet the price is
soaring. Here's why”, http://www.reason.com/news/show/125414.html, March 12th
2008

7
Some analysts have expressed the opinion that the traditional economic
philosophy of price as a function of supply and demand conditions has not
lost relevance altogether. At the same time, they also opine that the
participation of certain other factors in the oil market scenario is so effective
that they sometimes overshadow the part played by the market forces of
demand and supply in the movement of prices.

Speculation: Oil is purchased for cash and physical delivery made instantly
in the Spot Market. There is another kind of market called the Futures Market
where oil is traded only on paper. Not a single drop of oil need be handled by
the traders in the futures market. Futures Contracts are basically financial
instruments. The buyers and sellers of such contracts have the legal
obligation to take or make delivery of the underlying instrument at a
specified settlement date in the future. The two important markets in which
oil is traded in paper barrels15 are the New York Mercantile Exchange in New
York where the West Texas Intermediate crude is traded and the International
Petroleum Exchange in London where the North Sea Brent crude oil is traded.
The actual users of oil such as refineries, airline companies, etc trade in the
futures market to minimize the risk attached to the volatility of crude prices.
Others such as speculators and financial institutions look at it as a lucrative
investment option where they can earn huge profits by correctly guessing the
direction in which the price of oil will move in future. There is a lot of
controversy over whether spot prices dictate the course of futures prices or
whether the price of oil futures predict the future price of oil. A section of the
market opines that traders entering into a futures contract predict the
movement of future prices based on the prevailing spot price of oil. Another
section feels that it is the wild guess of these futures traders that triggers
drastic fluctuations in the current price of oil.

But no one disputes the fact that the existence of the oil futures market
which primarily functions on the basis of speculation has a major role to play
in rendering oil prices volatile in the global market. A speculative bubble is
said to have popped up in the international oil market which technically
means that fluctuations in prices are brought about by factors other than
economic fundamentals. The emergence of the oil bubble can be attributed
to the heavy influx of billions of dollars as investment in the oil industry for
trading purpose from large financial institutions, hedge funds, pension funds,
etc., which seek to diversify their portfolio and earn huge profits by taking
advantage of the volatility in oil prices. Most of these players are not actual
producers or users of oil, but are speculators who risk their capital in the
hope of reaping a rich return. The presence of speculative activity in the oil
industry is so formidable that the power to control prices has shifted from the
hands of the OPEC to the hands of speculators. Experts believe that the four
Anglo-American financial companies namely, Goldman Sachs, Citigroup, J P
Morgan Chase, and Morgan Stanley play a crucial role in determining the
price of oil. They invest heavily in oil futures and place bets on oil thereby

15
Paper Barrels refer to Crude oil or products traded on the forward or similar
markets which are closed out by subsequent sale or settlement without physical or
'wet' delivery.

8
inflating the price of oil. Goldman Sachs analysts have predicted that the
price of oil will continue to climb till it reaches $200 per barrel16.

Some speculators argue that their actions do not affect the spot price of oil in
any way as they deal only in paper oil. But statistics contradict their
contention. As of June 2006, the price of oil traded in the futures market
stood at about $60 per barrel. It was discovered by the US Senate
Investigation that at least $25 out of the $60 was due to pure financial
speculation. It can be deduced from this that almost 60% of today’s oil price
is due to financial speculation17. The world’s leading oil producing and
consuming countries attended the oil summit held on June 22nd 2008 at
Jeddah in Saudi Arabia to discuss about the oil crisis and explore possible
solutions to ease the situation. Most of them concurred that demand and
supply were in equilibrium and blamed speculation for the price rise. Chakib
Khelil, OPEC president and Algeria's Oil Minister quoted, "The price is
disconnected from fundamentals. It is not a problem of supply."18

Despite widespread criticism, speculators are doing everything possible to

maintain prices at a very high level because more than the producers, it is
the speculators who profit enormously from high commodity prices. 19 Oil
being the major lubricant for the global economy, the industry is largely
driven by beliefs and opinions rather than by facts and figures. This makes it
easier for the speculators to indulge in market manipulation. As long as they
can get sufficient number of people to believe that a certain factor will affect
the price of oil, they can succeed in doing so. That is why, even an event such
as rocket testing in North Korea has been linked to the rising price of crude
oil. They also draw heavily upon the Peak Oil theory to cause anxiety in the
minds of people. When people are worried about the impending scarcity of an
essential commodity like oil, its price will automatically shoot up.

Value of the US Dollar: The value of the US dollar is another important

determinant of the price of crude oil because oil is denominated in dollars.
Traditionally, a decline in the value of dollar would have meant that the US
economy is slowing down and the US being the largest consumer of oil, it
would have been presumed that the demand for oil would fall, thereby
bringing down the price of oil. But this perception has changed in recent
times. As there was a decline in the rate of return on investment in
stocks/equity, investors have turned their attention to the commodities
market where they can hope to earn huge profits by speculation in the price
movements. Oil being a dire necessity for every other economic activity, it is
on top of their list and investors believe that oil and dollar are alternative
forms of investment. Whenever there is a fall in the value of dollar, traders
16
STORY LOUISE, “An Oracle of Oil Predicts $200-a-Barrel Crude”,
http://www.nytimes.com/2008/05/21/business/21oil.html, May 21st 2008
17
Engdahl F. William, “Perhaps 60% of today’s oil price is pure speculation”,
http://www.globalresearch.ca/index.php?context=va&aid=8878
18
Wintour Patrick, “Demand, not speculation, at heart of oil shock, says Brown”,
http://www.guardian.co.uk/business/2008/jun/23/oil.saudiarabia, June 23rd 2008
19
Farmer John, “Speculators keep high oil prices in our futures”,
http://blog.nj.com/njv_john_farmer/2008/05/speculators_keep_high_oil_pric.html, May
23rd 2008

9
tend to invest more in oil, thereby inflating its price. Whenever the value of
dollar appreciates, they invest more in dollars causing oil prices to fall as oil is
pegged to the dollar in the international market. Consequently, the price of
crude oil and the value of dollar move in opposite directions (Exhibit IV).

Exhibit IV
Inverse Relationship between value of dollar and price of oil

Source: Goldman David, “ Fed could burst oil's bubble”,

http://money.cnn.com/2008/04/29/news/economy/oil_dollar/index.htm

Subsequent to the sub prime crisis and consequent instability in the US

financial sector, there was depreciation in the value of dollar against the Euro
and other major currencies. Canada being the largest exporter of oil to the
United States, the value of the Canadian dollar appreciated by over one cent
against the US dollar as of August 21st 200820. This has made investment in
dollars unattractive prompting investors to lock their capital in oil futures
which was considered to be the next best investment option. To that extent,
the surge in the price of oil is linked to the fall in the value of dollar and not
due to any extraordinary growth in the actual demand for oil.

Geo Political Factors: Analysts believe that geo political factors can
influence the price of oil significantly because most of the world’s rich
reserves of crude oil are located in countries which are politically and
economically unstable. The crisis experienced by the oil industry of late and
the relative instability in leading oil rich countries stands testimony to their
assertion. Iraq is the second largest crude oil reserve holder in the world. Its
post-war struggle to rebuild its disintegrated economy and to raise oil
production to pre-war levels is looked upon as an important reason for the
escalation in oil prices The quantum of oil produced by Iraq has reduced
drastically after the war. This is construed as a reduction in supply, and hence
the rise in price. The tug of war between Iran, the fourth biggest producer of
crude oil and the United States, the largest consumer of oil in the world over
the former’s nuclear program plays an important role in moving oil prices
forward. Oil production in Venezuela, the seventh biggest reserve holder is
said to be suffering from faulty policies of the government. Lack of foreign
20
Pingue Frank, “Canadian dollar posts big gain as oil prices rally”,
http://www.financialpost.com/story.html?id=739834, August 21st 2008

10
investment and technical expertise, diversion of oil revenue to investments in
social programs and other issues are some of the major challenges facing the
oil industry in Venezuela.21 Nigeria, which is Africa’s biggest crude producer,
is the eighth largest exporter of oil in the world. Most of its reserves are found
in the Delta of Niger which is inhabited by the Ijaw tribe. There is constant
strife between the government and the Ijaw tribe over the issue of sharing of
profits from oil exports. Violent terrorist attacks on oil facilities and assault on
oil field workers are seriously affecting the quantum of oil produced in
Nigeria.22

The oil market is not a free market. The laws of demand and supply are not
able to operate freely because of the existence of subsidies and price controls
in oil consuming countries. This results in market distortion as the price of the
product does not reflect the real cost of production. In such a situation,
demand fails to adjust itself in accordance with the changes in price. A large
share of the growth in total world demand for oil can be attributed to
emerging economies such as China and India. The governments in many of
these rapidly expanding economies shield their consumers from high oil
prices through subsidies and price controls. If the full brunt of the high cost of
oil is not passed on to the consumers, they do not recognize the gravity of
the situation and continue to use more and more oil. That is why a large
section of the international community is not responding to the current oil
price shock. For example, developing countries such as China and India
spend billions of dollars on oil subsidies and they are among the top ten
consumers of oil in the world. In China, between the first quarter of 2007 and
that of 2008, the demand grew by additional 400,000 barrels per day
although the price of oil was reigning supreme. During the same period, the
demand for oil from industrialized countries fell by one million barrels per day
whereas in countries with high energy subsidies, it grew by 1.1 million barrels
per day. According to the estimates of IMF economists, the industrialized
nations with very little or nil subsidy are expected to demand about 1% less
oil during the year 2008-2009 The demand from developing countries for the
same period is expected to grow by 3%. Thus when one section of the market
responds to the high price by cutting down its demand, it is more than offset
by the rise in demand from another section which is unmindful of towering
prices in the international market. Subsidy is thus considered to be the main
culprit behind the supply-demand imbalance. But the governments in many
of these countries are reluctant to resort to the politically unpopular move of
removing subsidies. Today the price of oil per barrel is thus a reflection of
these geo political reasons23.

Changes in climatic conditions and natural calamities also have the potential
to impact oil prices. In 2005, when hurricane Katrina hit the southern coast of
the US, it sent oil prices soaring as oil and gas production in the region had to

21
Fleischer R. Lowell, “Venezuela May Rival Canada Oil Sands as Chavez Seeks
Investors”, http://www.cebri.org.br/pdf/333_pdf.pdf
22
Mahtani Dino, “NIGERIA: Nigerian oil industry helpless as militants declare war on
Obasanjo”, http://www.corpwatch.org/article.php?id=13289, February 21st , 2006
23
“ The Cost of Oil Subsidies”,
http://www.nytimes.com/2008/08/01/opinion/01fri3.html, August 1st 2008

11
be shut down. When a devastating earthquake struck China's southwestern
province of Sichuan in May 2008, the price of crude oil rose in the world
market. Logically, the price should have fallen due to the set back in
economic activity in the most populated country of the world subsequent to
the earthquake. But it increased instead because it was feared that China’s
longest fuel pipeline might suffer the risk of damage from an earthquake lake
which will cause disruptions in supply.24 This is yet another example of the
fact that psychological perceptions play a key role in the functioning of the oil
market. More recently, the market witnessed a drop in the price of oil when
the tropical storm Fay made landfall along the southwestern coast of Florida
as a weaker storm on August 19th 2008. It was earlier feared to be a
hurricane25.

Clearly, the price of oil is no more determined by demand and supply

conditions alone. But there are some Economists who believe that like any
other commodity, it is still the forces of demand and supply only that move
the price of oil. In their opinion, the difference can be found in what
ultimately drives the market forces of demand and supply; in the case of oil,
it is a definite shift from economic fundamentals to non-fundamental
elements which have come to hold their sway over the oil market.

The Road Ahead

Galloping crude oil prices can have far-reaching consequences on the

functioning of the global economy. If the spurt in price has been caused by an
increase in economic growth driven demand, it will augur well for the
international community. On the other hand, if the price rise is the result of
speculative demand, it will seriously impair the health of all the economies.
The effect on individual economies will be either positive or negative
depending on whether the country is a net exporter or importer of oil and on
the extent to which the country is energy-intensive. In general, very high
crude oil prices will greatly benefit the OPEC and other oil producing nations.
As can be seen in recent times, the oil exporting countries are filling their
treasuries with petro-dollars. But the level of economic prosperity that these
countries can attain will depend on factors such as the cost of production of
oil, need for importing other goods and services and on how best they utilize
the excess revenue generated by way of oil exports.

The effect on importing countries will no doubt be negative when there is a

steep increase in the price of oil. These countries will have to earmark a
larger percentage of their income to meet the energy bill. Therefore, they
will be left with less money to spend on other products which will lead to a
decline in demand for these products. The resultant production cuts and

24
As many as 30 lakes were created by landslides touched off by the earthquake in
China
25
Bianchi Chris, “Oil price falls as Fay becomes no hurricane”,
http://www.climatechangecorp.com/content.asp?ContentID=5564, August 19th 2008

12
increase in unemployment will throw the economy into a recession. However,
higher crude prices tend to hit the developing and transition economies
harder than the industrialized countries. This is because the dependence of
developing countries on imported oil is greater than that of industrialized
countries. Many of the developed countries manage to meet at least a part of
their oil requirement through domestic production and also use energy more
efficiently. But the developing countries are more energy intensive, i.e., more
than 50% of the energy supply is consumed by the industrial sector and also
use energy less efficiently.26 It has been estimated that on an average, the
developing countries use more than twice as much oil as the advanced
nations to produce a unit of economic output.

The implications of high crude prices transcend a mere transfer of income

from importing countries to exporting countries. The oil rich countries may
enjoy surplus revenue in the short run. Viewed from a long term perspective,
the high cost of crude will be detrimental to all the countries irrespective of
whether they are oil importers or exporters. Even if the price hike is the result
of a growth-driven demand, beyond a certain limit, it will adversely affect the
global economy. When oil and gas prices rise, there will be a corresponding
increase in the price of other essential commodities. With oil prices soaring
over $100 per barrel, food prices are ruling the roost and the governments in
many countries are struggling to cope with the ills of double digit inflation.
For example, India, which meets nearly 70% of its oil requirement through
imports, has been reeling under double digit inflation ever since the price of
oil started soaring to unprecedented levels27. The inflation rate stood at
12.63% for the week ended August 9th 200828. The oil producing countries
are equally affected by the phenomenal increase in food prices because most
of them have to import food grains to meet domestic requirements. In many
of these countries, the heavy expenditure on food and other imports more
than offsets the extra revenue earned from oil exports. Moreover, the decline
in economic activity in importing countries due to the high cost of oil will lead
to a fall in demand for oil which will affect the export potential of oil
producers. Apart from this, demand can also diminish when in the long run,
consumers cut down their oil consumption either by switching over to fuel
efficient forms of transport or by moving closer to their place of work. Thus
high oil prices have the potential to plunge the global economy into a
recession.

The absence of free market in the case of oil is a significant factor

contributing to wild fluctuations in its price. Governmental intervention in the
form of subsidies and price controls prevent the oil market from attaining
equilibrium through the automatic adjustment of market forces. According to
a 2007 estimate of the oil company BP, 96% of the global rise in oil usage is
26
McKane Aimee et.al., “ Policies for Promoting Industrial Energy Efficiency in
Developing Countries and Transition Economies”, http://industrial-
energy.lbl.gov/node/395
27
Masih Niha, “The Tale Of Double Digit Inflation”,
http://theviewspaper.net/business/2008/07/3663, July 13th 2008
28
Sethuraman S., “How long will India's double digit inflation last?”,
http://www.commodityonline.com/news/How-long-will-Indias-double-digit-inflation-
last-11322-3-1.html, August 25th 2008

13
from countries which had oil subsidies. As many as 50 countries keep the
price of oil in the domestic market artificially low by allowing subsidies and
tax breaks. Therefore the demand from these countries grows unabatedly
notwithstanding the high price of oil29. Economists are unanimous in their
opinion that oil price shocks can be avoided only when the price is
determined by the free play of market forces and the same is fully passed on
to the consumers without any subvention. Another adverse effect of subsidies
is that there is no incentive to conserve and use oil more efficiently as
consumers do not feel the real pain of paying the high cost. The Americans
who have a penchant for gas guzzling cars have started switching over to
energy efficient vehicles such as hybrid cars whereas the Chinese are buying
more and more big cars despite the high cost of fuel.

Countries which predominantly subsidise oil and gas prices have their own
justification for continuing the administered price regime. They contend that
their aim is to protect the poor from the ravages of sky-high prices. In reality,
the rich who own big cars and fly frequently and the highly energy-intensive
companies are the ones who are greatly benefited by the subsidies. Since
these industries are substantially mechanized, they do not contribute in any
way to bring down the rate of unemployment in the economy. Hence experts
strongly advocate the elimination of subsidies and advise governments to
decontrol oil prices. They are also confident that free market will eventually
prevail in the oil industry because the unrelenting upward shift in oil prices
and the corresponding increase in subsidies are causing a severe strain on
the finances of the developing countries. That is why many countries
including China, India, Malaysia and Indonesia have raised the price of petrol,
diesel and gas in their domestic markets despite opposition from various
quarters, though the increase in price may not be commensurate with the
increase in global oil prices. The Organisation for Economic Co-operation
and Development (OECD) group of countries have also been persisting their
demand for a free market sans subsidies because in spite of striving to
preserve oil, they are forced to pay a high price due to the reckless use of oil
by consumers in developing countries.

Some experts look upon the oil crisis as a blessing in disguise.

Environmentalists feel that the vertical movement of oil prices has its own
advantages. It has created awareness among people about the peak oil
concept and the need for conserving oil. The peak oil theory is a highly
debated issue in the oil market arena. Some analysts believe that the
concept has been invented by speculators keen on pushing prices
continuously in the upward direction. Others contend that the world has
indeed reached the peak oil status where there is no more oil left under the
ground to be mined and refined. There are some others who take the neutral
stand. In their opinion, whether the peak oil theory is valid or not, it is true
that oil is a finite, precious and non-renewable resource. Hence the present
crisis is an excellent opportunity to educate people about the advantages of
using oil prudently. It has also accelerated the pace of research and
29
Zwaniecki Andrzej, “Government Subsidies Keep Oil Demand Inflated in Emerging
Markets”, http://www.america.gov/st/econ-
english/2008/August/20080814172401saikceinawz0.4823267.html, August 14th 2008

14
development in alternative forms of energy such as wind, solar, biofuels, etc.
Special interest has been evinced in the development of biofuels which are
considered to be almost near perfect substitutes for fossil fuels. The use of
biofuels has also generated a lot of controversy. Biofuels are generated from
biomass and involve the conversion of living organisms like plants into fuels.
Unlike fossil fuels, biofuels are a renewable source of energy which can be
replenished from time to time. The carbon emissions from biofuel based
vehicles are significantly less when compared to petrol or diesel. Thus
biofuels ensure a greener and cleaner environment. The controversy stems
from the extensive use of food grains like corn for producing biofuels.
Increased use of agricultural land and food grains for developing biofuels has
further aggravated the problem of rising food prices. The economically
weaker sections of the population are finding it difficult to afford even the
basic minimum required to keep them alive and hence the stiff opposition to
biofuel development. “When millions of people are going hungry,”
Palaniappan Chidambaram, India's finance minister declared, "it's a crime
against humanity that food should be diverted to biofuels.30"

Apart from this, another obstruction in the way of developing alternatives to

fossil fuel is the fact that the very process of innovation requires large
quantities of the fossil fuels which are sought to be replaced. The plant and
machinery to be installed to undertake such researches will require large
quantities of oil and energy for their day-to-day operations. The high cost of
inventing and innovating in this field is a deterrent to many countries from
investing in such ventures. Some analysts even feel that once the cost of
crude oil comes down to reasonable levels, there will be no takers for the new
resources that will be developed at great cost and effort. In spite of these
reservations, specialists are continuing their research in this direction with
great enthusiasm and it can be expected that sooner or later they will come
up with an affordable alternative source of energy which will put an end to
the monopolistic control of crude oil.

The process of innovation will not yield results in the short term. It will take a
long time to develop the alternative resources and to make them operational.
Therefore, it is wise to concentrate on oil conservation efforts to solve the
problem at hand.

30
Brownfeld C Allan, “Subsidizing Ethanol: The Unintended Consequences of Market
Interference”, http://www.fgfbooks.com/AllanBrownfeld/Brownfeld080812.html,
August 12th 2008

15