Understanding Oil Prices

October 29, 2002

This article appears in Petrol News, Sultan Qaboos University, Spring and Summer, 1999, Issue 2.

In recent months, the price of oil has dropped gradually but systematically to about one half of its 1996 price of over US$20 per barrel. Then, on one day in March, it rose back to about US$14-15 per barrel, where it seems to have stabilized at least temporarily. Since a number of countries rely on oil revenue to support their economies, many people in those countries want to know the causes of these changes. To understand oil prices, it is necessary to know two things: (1) the economics of oil markets and (2) how speculators affect the price of commodities like oil.

The economics of oil markets assumes that oil prices rise and fall to a greater extent in the short run than they do in the long run. The reason is that it takes time for consumers and producers to adjust to changes in demand and supply. In late 1979, when Saudi Arabia and the OPEC countries reduced their supply of oil, they expected only a small decrease in the quantity of oil demanded. They correctly anticipated that their oil revenues would rise. At that time, the price of a barrel of oil was about $10.

The reason for the short run rise in revenues is that consumers and producers of oil products like gasoline did not have time to fully adjust to the change in price. First consider the consumers. If automobile drivers expect the prices to remain high for a long period, they will do many things to economize on their use of gasoline. They will shift from high gas-consuming vehicles to economy cars; from private cars to public transport and other forms of transportation; and from driving alone to car pools. They will also move closer to their work and do more of their work at home. Heating oil users also will adjust their thermostats during winter, increase the insulation of their homes, and wear more clothing.

Adjustments like these will occur throughout the markets for products that oil is used to produce. But the adjustments take time. In the short run, the amount of oil demanded fall slightly, giving oil producers a bonanza in increase revenue.

Adjustments in demand are not the only reason for the decline in oil prices following the OPEC cutback in 1979. There were also adjustments in supply. When suppliers of oil expect prices to remain high for a long period, they make several changes. They uncap wells that were previously capped due to high costs, they drill deeper for oil that they regarded as previously unprofitable to pump, and they increase their exploration in the hope of finding new, low-cost sources. In the short run, the higher price raises quantity supplied slightly but in the long run it raises it substantially.

The combined pressure of a falling demand (or a less rapid increase in demand) and rising supply eventually caused the high oil prices of the 70s to fall. The high oil prices lasted only until 1986 when oil prices suddenly fell to less than 50% of their early 1980s average to $12.50 a barrel. The long run had arrived. Or at least speculators believed it had. For the next ten years, prices varied only slightly around the average of about $15 per barrel.

If we disregard the brief jump in during the Gulf War period of 1990, we can say that oil prices in the late 1980s and most of the 1990s were driven by two important factors. The first was rising world demand especially in the rapidly developing Asian economies. The second was technological advance, which reduced the costs of exploring, drilling, pumping, refining, and transporting. While the rising demand helped to assure the prosperity of the major oil-producing countries, technological progress limited this prosperity.

This situation changed abruptly beginning in 1988 with the Asian financial crisis. Demand for oil products from countries or territories like Japan, South Korea, Taiwan, Singapore, Hong Kong, Thailand, and Indonesia fell sharply. The result was a sharp fall in oil prices to less than two-thirds of their average level during the 1990s. As time passed, the oil demanded by U.S. and European consumers increased. In addition, supply decreased. Oil suppliers practically stopped exploring, they abandoned plans to exploit deep and costly oil pools, and they capped some existing high-cost wells.

These consumer and producer decisions would have eventually caused oil prices to rise. However, in late March 1999, they suddenly rose by 50% in less than a week. How could this happen? The answer is speculation. Although fundamental changes in demand and supply take time to have their effects, large speculators can cause prices to change very quickly. When speculators heard that oil companies had plugged some of their higher-cost wells, they took this to mean that the cutback in supply would, before long, cause oil prices to rise. So they stepped in quickly and tried to buy the low-priced oil before it rose in price. This increase in speculative demand for oil cause the actual price of oil to rise sharply.

If the speculators are correct, oil producers can continue to expect prices around the $14-$15 per barrel level for the indefinite future. However, no one can be sure when the Asian economies will begin their recovery and, therefore, when demand for oil will pick up. As soon as speculators are convinced that Asian demand will rise, they will bid prices up sharply again. But the initial rise will be followed by a gradual fall in oil prices for two reasons. First, demanders will begin their long term adjustments by economizing again on their uses of fuels. Second, suppliers will open up some capped wells, they will explore for more oil, and the incentive to reduce costs through improved technology will return.

And so it is with oil prices. Prices rise and fall because of fluctuations in demand and supply. And speculators act to predict the rise and fall, thereby hastening the adjustments by demanders and suppliers to the changes.

Gunning’s Address
J. Patrick Gunning

Professor of Economics/ College of Business
Feng Chia University
100 Wenhwa Rd, Taichung

Taiwan, R.O.C.
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