More explanations for high oil prices

Here are some more explanations for the rising oil prices.

1. A number of economists and oil industry analysts claim that expectations of higher future prices discourages oil producers from extracting more oil. James Surowiecki quotes Daniel Yergin's "shortage psychology" which claims that more than many other commodities, the price of oil is based not only on current supply and demand but also on people’s expectations about future supply and demand. These expectations determine whether it makes sense for oil producers to sell their oil now or leave it in the ground and sell it later.

2. Martin Feldstein argues that increasing demand and the specific market conditions have been responsible for the steep increase in commodity prices. In a market with booming demand and overflowing work orders (for companies using these commodities as inputs), demand is price insensitive in the short (and even medium) run. The problem is compounded by the difficulty (or even impossibility) in increasing production in the short run. It therefore takes a very large increase in price (atleast in the short run) to bridge the global demand supply mismatch.

Taking the example of corn, Prof Feldstein sums up the arguement, "With a very low short-run price sensitivity of demand and little scope to raise supply in the short run, even a relatively small increase in corn demand by the high-growth economies can lead to a very large short-run rise in the price of corn."

The case of oil (and other mineral commodities) is complicated by the fact that it can be stored on the ground (by cutting down production) without incurring the direct costs associated with storage. As Prof Feldstein writes, "A simplified answer is that the oil producer will keep the oil in the ground if its price is expected to rise faster than the interest rate that could be earned on the money obtained from selling the oil. The actual price of oil may rise faster or slower than is expected, but the decision to sell (or hold) the oil depends on the expected price rise."

Given the dependence of spot prices on the expected future price of oil, Prof Feldstein claims that any policy that causes the expected future oil price to fall can cause the current price to fall, or to rise less than it would otherwise do. In other words, it is possible to bring down today's price of oil with policies that will have their physical impact on oil demand or supply only in the future.

If we agree to this arguement, the two main prescriptions to lower the prices are - increase supply (by increased investments in extraction) or reduce consumption demand (by investing in energy alternatives).

3. Some others argue that the present rise in oil prices is a natural phase in the 20 year energy cycle. From the mid-1980s to the middle of this decade, oil prices fell even as the world economy grew. A barrel of crude cost $68 in 1983 (adjusted for inflation) — and just $33 in 2003.

The high prices of the early 1980s gave producers an incentive to take more oil out of the ground and also gave consumers reason to use less of it. With supply growing quickly and demand growing less quickly, prices plummeted. The low prices of 1990s reversed the incentives - consumers splurged on cheap oil and investments in new oil fields stagnated.

4. Another contributor to the high oil prices has been the decline in dollar since 2001. With a large part of the global energy trade being denominated in dollars, the declining dollar magnified the price rises. According to Stephen P. A. Brown at the Federal Reserve Bank of Dallas, without this decline, a barrel of oil would cost less than $110 today, rather than $141.

5. There are others who see the expectations of higher future prices as causing significant distortions in incentives, causing agents to hoard or hold back supplies from the market. For example, some see the oil tanker fleet as a large storage source, responsible for holding back significant amount of oil. Sample this example. A typical very large crude carrier (VLCC) holds around 300,000 metric tonnes. At 7.3 barrels per tonne and $135/bbl this makes the cargo of 2.19 million barrels worth about $296 million. Assuming the VLCC floating storage rate at around $150,000 a day, the storage cost per barrel is between 6 and 7 cents per day.

At $135 per barrel, for every 1% increase in price you could pay for around 20 days of storage. Twenty days back crude was riding at $135/bbl, while it is $140/bbl today, a gain of $5/bbl against a storage cost of $1.37 incurred. Add to this the cost of locking up $135 worth funds for 20 days, amounting to $0.42, and the net cost incurred is only $1.80/bbl. The net gain over a 20 day period is a handsome $3.2/bbl, or a cumulative profit of over $7 million on the 2.19 m barrel stock.

Closely related to this is the arguement that a large amount of stocks are locked up in the tanks of automobiles. It is claimed that the expectations of continued rise in prices is driving people to top up their tanks and even store stocks in their basements. When added up over the millions of vehicle owners, this is a significant quantity. However, there have been no detailed evidence to prove this claim.

Update 1:
Here is the estimated oil stocks of all major oil producers. At today's rates of production, the world has enough oil to last for almost 42 years.