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Economic Monthly Report

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Once again it's oil

Mon, Sep 22 2008, 12:26 GMT
by La Caixa Economic Research Dept.

La Caixa

In July the per barrel price of oil reached a new all-time high. A year ago, when the price was barely hitting half of the 146 dollars seen in July, such a level seemed possible only in a situation where oil supply had been suddenly cut. But that was not so, the flow of buying and selling was following its normal course except for the usual inevitable odd problems of supply. From that moment on, in just a few weeks the price of oil was sharply corrected and went down to 110 dollars, a level that in any case was still well above that expected one year earlier. Why is the price of oil going so high? And why is it so volatile?

These are questions that operators and analysts have been trying to answer now for many years ever since the first oil crisis at the beginning of the Seventies sharply hit the industrialized economies. In recent years, it is clear that one of the factors in this rise is to be found in the boost in demand from the emerging countries. The rapid industrialization of those countries has turned them into hungry oil consumers. China, of course, heads the list as the main country responsible for the rise in consumption. On the other hand, in the advanced economies, which still represent 60% of world demand, oil consumption seems to have become stable since 2006 as a result of the rise in prices and economic slowdown.

While oil demand has kept going up sharply, supply has barely been able to cover buyer requirements. It should be borne in mind that over the short term supply is relatively inflexible given that increasing production capacity is a long and costly process. It requires a considerable initial investment in oil-field exploration and then it takes an average of between five and ten years before these can be made productive. Furthermore, oil exports are confined to just a few countries and these often suffer from internal or geopolitical instability, as is the case of the Middle East, Nigeria, Venezuela and Russia. There is plenty of oil but as it is a finite resource there is a growing fear that supply will soon reach a ceiling (the peak oil theory) so that the current price is nothing more than a foretaste of what inexorably lies ahead.

Increased demand and rigidity of supply could account for the upward trend in the per barrel price in recent years but this does not quite explain the sky-rocketing rise seen over the past year. Inevitably, attention has shifted to commodity investors. In recent years, many of these have included oil in their portfolios, a trend that seems to have been stepped up following the world financial crisis that began in August 2007. The meteoric price rise in the past year has coincided with the boost in funds being invested in oil futures. The recent price drop is being attributed to a withdrawal of investors from this market.

The correction of oil prices, however, does not remove a situation that could be termed an oil shock, given that it is a matter of a 70% increase in one year. Traditionally this has meant more inflation, lower growth and less employment. However, more and more the impact of the energy crisis seems to be of lower degree. In fact, as of 2000 the price rise in oil has coincided with the sharpest and longest growth cycle in the world economy in 30 years, in a context of low inflation and lowlevel unemployment. We should not lower our guard but it certainly would seem that the oil-dependent economies are more and more able to withstand the blows from the per barrel price of oil.

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Published on  Mon, Sep 22 2008, 14:37 GMT