A barrel a month, keeps your money away

With the price of oil getting higher and higher, consumers' budgets get tighter and tighter. This week, we have seen another record high for the price of oil, we have also seen the price of oil jumped from $127 to $138 in a single day. Now Goldman Sachs is predicting that the price will go up to $150 a barrel. Russia's Gazprom even said that the price of oil will increase to $250 a barrel next year. One might ask, "why is this happening?".


A lot of consumers think that the reason for this hike is because oil companies are getting greedier and because these companies know that the demand for oil is very inelastic, they can increase the price to as high as they would like. We also have people blaming the speculators for the problem, so what is the main reason for the price of oil that seem to have no limit?


There is no one main reason for this, rather, it's a series of unfortunate events that created it. I will try to break them down one by one, I will also talk about those that I think played no factor in the rise. First up, and I will go for the easy one, and that is the oil companies and if they are just getting hungrier for money. Many consumers think that these companies are like monsters that eat into people's pockets and their appetite is getting larger by the day. So, if this theory stands true, why does the oil price go down? It's quite obvious that this is not the main problem.


Then, there's those speculators. For those of you who don't know what speculators are, they are people that trade the futures of oil, in other words, they gamble if the price of oil will rise or fall. All they do is by trading papers and when they mature, they can settle them with a cash payment or sell them on to genuine consumers. One funny thing about economics is that, people do business solely by using their own expectations about the future, which are informations that were picked up from the market. Because of this, when speculators buy contracts that say the price of oil will be $200 in six months time, the demand at this moment will shoot up. This might be confusing at first, but if we look at it this way, say that today's price of oil is $150, and if a person buys a barrel right now, and sell it six months later, he would have made a profit of $50. Where I am going with this is that, as more and more people believe that the price of oil will keep on rising, and we know that supply will remain the same in the short term, demand will increase as people fear they will have to pay a lot more in the future.


All these come to a conclusion, the price of oil is the direct result of the mechanism of the basic economic model of supply and demand. During the last few years, the supply has grown by a little. On the other hand, the increase in demand, especially from the developing countries, has been outweighing the increase in supply. So why don't the refineries build new equipments or develop new oilfields to make the extraction of oil more efficient? It's because investing in the extraction of oil is time draining and requires a lot of capital. Also, since each refinery can be used for decades, these firms will have to be prudent in making decisions to invest. Moreover, it is also difficult to get the right permits to start construction. The cost of developing new fields has risen even faster, plus, we have these environmentalists protesting every now and then about the pollution these refineries produce. Although many geologists believe that there are still a lot of oil to be discovered in the Middle-East and the former Soviet Union, the regions' governments, as well all know, can be stubborn at times in allowing outsiders to have access.


If the economic model stands correct, that when the price increase, demand decreases, why do we see so little downward movement in the level of demand? Although demand in rich countries has been dropping for the past two and a half years, the thirst for oil in developing countries like China, India and Brazil has overshadowed the drop. But it is still weird that the rise in consumption in these countries(though at a slower pace) don't fall as much as we might have expected. This is partly because their economies are growing faster, but also, for countries like China, India, Malaysia etc. their consumers do not feel the rise in the price of oil through subsidies from their governments. This means that in some parts of the world, petrol is not sold at the market price. According to the newspaper I read, the cheapest petrol is in Venezuela, at 5 cents(US dollars) per litre, and China's price is at 79 cents, and then we compare that to United States' $1.04 per litre. With the price of oil rising each and every day, the cost of subsidies must rise too, and sooner or later, governments will have to lift prices. The main reason they need to subsidies oil is because if they had not done so, these countries' inflation would have been pushed through the roof. In order to keep their economies going at full speed and to avoid their consumers protesting and rioting(We have to remember that these countries' political situation are all not very stable, the only thing that keeps them quiet is by increasing their wealth and lowering their cost of living, or by force) like those truckers in Spain, they had to shield their consumers from the rising cost of fuel. Some governments believe that by capping the price of oil, they can in turn help the poor. What they did not consider is the fact that the poor cannot afford oil in the first place, if they never had a car, how are they going to consume petrol. Rather, this only helps the rich and industries that are energy intensive.


These problems cannot be fixed in the short term, as mentioned earlier, demand and supply for oil is quite inelastic. People need time to replace their old cars with new hybrid ones, or to move to more urban areas where they can easily have access to public transport. Also, it takes a long time to develop a new oil field after discovery. In the long term, the level of supply will rise and demand will drop. But for us, the consumers, the near future does not look so bright.