Inflating the oil crisis
What's behind the hike in prices?
What’s behind the rise in oil prices? Not scarcity, according to OPEC President Purnomo Yusgiantoro: ‘OPEC already oversupplies, but oil prices are too high…. This is not a supply and demand balance problem. This is not because of fundamental factors.’ (1)
He’s right. The problem is that the markets are worried by a series of risks, in Iraq, Venezuela, Russia, Nigeria, and elsewhere, rather than that there is an oil shortage. Are the markets right to be spooked? And if the real risks don’t measure up to market expectations, why are they so concerned?
First it is worth noting that, despite the headlines, oil is not at historically high prices. The headlines are only justified by ignoring inflation – which is to say, they are not justified. Record oil prices followed in the wake of the Iranian revolution – in 1981 the average price of oil was $31.77 a barrel, the equivalent of roughly $60 today. The peak price, in February 1981, was $39.00, or about $73.50 in today’s money. This is substantially more than the $48 (or so) that oil actually costs us now.
Even so, set against reasonable expectations, today’s prices are high – and these high prices reflect broader worries in society about energy. The most immediate concern is instability in the Middle East, and Iraq in particular. There is a common view that reliance on Middle East oil imports is a big problem: President George W Bush, as well as his Democratic rival John Kerry, is offering a plan for American energy independence.
The Middle East is part of the wider concern about energy insecurity in a world in which we are dependent on imports for energy. In the UK, news that Newcastle is to begin importing coal captured a mood of uncertainty about a future in which we will be more reliant on imports, especially natural gas.
But a more interdependent world is not necessarily a more risky one. In fact the opposite is true. With respect to oil, the markets have got it wrong. The developed world is actually less dependent on energy for economic growth, less dependent on oil for energy, and less dependent on the Middle East for oil.
We are less dependent on energy for economic growth in the sense that, after an early phase of industrialisation, developed economies consistently require less energy for each additional unit of economic growth. Energy intensity (energy per unit GDP) peaked in the USA in 1920, and by 2000 had fallen by about 60 per cent of this peak (2). Improved efficiency resulted in the proportion of US GDP spent on energy falling from a peak of 13.7 per cent in 1981 to 7.2 per cent in 2001 (3).
We now derive a greater proportion of our energy from other sources. The main increase has been in natural gas (whose sources overlap, but are not identical with, oil) and nuclear power:
Source: Key World Energy Statistics, International Energy Agency, p6
The change has been even more marked in the Organisation for Economic Cooperation and Development (OECD) countries:
Source: Key World Energy Statistics, International Energy Agency, p7
Furthermore, reliance on the Middle East for oil has decreased from 36.9 per cent of supply in 1973 to 28.5 per cent in 2002. The USA has become more reliant on imports, but this does not mean imports from unstable regimes. There have been small increases in the share of oil coming from Africa, Latin America and Asia, but the bulk of the increase has come from OECD countries, mainly from the North Sea and Canada, whose share of production rose from 23.7 per cent to 28.4 per cent.
Source: Key World Energy Statistics, International Energy Agency, p12
There is little long-term basis, then, for believing that the risks associated with oil supply have increased. Indeed, the benefits of globalisation and development are ignored, while the downside is constantly exaggerated. Prices aren’t driven by real problems, but rather by a constant anticipation of problems.
Venezuela’s referendum on the recall of President Hugo Chavez is a good example. In the days leading up to the referendum the possibility of trouble and interruption of the oil supply was overblown. But even once the referendum had passed peacefully it only had a small impact on price, as if actual events were less important than fearful perceptions.
The legal problems of the Russian oil company Yukos is another issue that has been over-hyped. Whatever the personal dispute between President Putin and former Yukos CEO Mikhail Khodorkovsky, the chances that Russia will stop exporting oil are virtually nil.
Even in Iraq, where attacks have caused real disruption of oil exports, it is questionable whether the risk is as high as assumed. Iraq’s largest pipeline has been repaired after suffering an attack, but it has been closed since 9 August for fear of future attacks. With a capacity of 1.5million barrels per day, this 48-inch pipeline alone could supply over one per cent of world demand.
In this climate anything can be talked up as a reason for higher prices: a hurricane in the Gulf of Mexico, a fire at a refinery, ongoing low-level conflict in Nigeria, and next week, perhaps, who knows what. The result is a financial bubble in the oil market, which has the potential to persist for some time or to quickly collapse.
It is worth noting the changed conditions that make a bubble of this sort more likely. Ever since the New York Mercantile Exchange began trading crude oil futures in 1983, energy markets have become increasingly ‘financialised’. Elaborate contracts mean that for each dollar ultimately spent on oil, middlemen are exchanging ever more dollars on side deals and insurance. Symbolic of this development has been Enron, where fraud flourished among increasingly complex financial arrangements. The result is that energy prices become more tied to the financial markets than to actual production, leaving more scope for swings in price and bubbles.
There are two important causes of financialisation (5). The first is that investment in the financial markets is now easier than investment in manufacturing or services, which is increasingly regulated and seen as risky. The second is that investment in financial derivatives is seen as a good idea as a form of risk management. By entering into a futures contract, for example, you might pay a little more for the benefit that prices can be fixed ahead of time – which eliminates the risk from prices changing between now and when the oil is needed. Other contracts work as more elaborate forms of insurance.
The consequences are mixed. On the one hand, the availability of various futures and options is a boon to many companies who can now buy insurance against unexpected changes in price or demand. The occurrence of bubbles can also have the opposite effect, leading to swings in the revenue of oil companies and governments. The one sector that can benefit whether the price is high or low is the financial intermediaries, the traders. Of course, this gives all parties a greater incentive to make financial activity a more important part of their business.
The cut taken by the oil traders represents a redistribution of resources from other sectors of the economy toward risk management and insurance. Behind these economic developments lies a suspicion of globalisation and of development, with the downside of progress continually being emphasised. The more that these trends become institutionalised, the more positive economic opportunities are likely to be missed.
(1) Non-OPEC countries urged to pump more, International Herald Tribune, Monday, August 16, 2004
(2) Energy at the Crossroads, by Vaclav Smil, MIT 2003, p68
(3) Energy Information Administration / Annual Energy Review 2002, p13
(4) Calculated from BP Statistical Review of World Energy 2004, Key World Energy Statistics, International Energy Agency and US Census Bureau, Total Midyear Population for the World
(5) See generally Cowardly Capitalism, Daniel Ben-Ami, Wiley 2001
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