The price of oil in the 1960’s and early 1970’s was very low and relatively stable at about $0.015 per liter. However, this price started rising sharply from 1973 ($0.08 per liter). This price stabilized for around five years. It rose again sharply peaking in 1980 at around $0.23 per liter (Figure 2). The price of oil began to fall steadily from this peak for about five years before falling sharply in 1986 to around $0.09 per liter. For the next fourteen years, the price remained relatively low and stable, fluctuating between $0.08-0.14. The price again started to rise from the year 2000 (around$0.18) surpassing the $0.23 mark in 2004. It rose steadily until for four years before rising sharply in 2008, peaking at around $0.62 per liter. It again fell sharply the next year to about $0.39 per liter. The price of oil in 2010 was around $0.5 per liter.
The rise in 2008 was distinct because, in just one year, the rise in oil price was the sharpest since the 1960’s and it was the highest ever price. The rise in petrol was more than it had in the past seven years (AA, 2007; 2008). The rise in oil prices can be attributed to the normal phenomenon where prices tend to rise over time due to inflation, especially as the value of currencies fall.
The demand for oil has been increasing due to many factors. For example, the average incomes of the peoples have been rising over the years (Scheuble, 2011). Hence, the people travel more, consume more products, buy more electrical appliances, use air conditioners, install heaters in their homes and other stuff that use oil. Therefore, they tend to demand for more oil. Additionally, there are not many adequate substitutes for oil in the market today. Yes, the price of oil has been increasing, but also the price of substitutes like natural gas has also been rising (Trading Economics). People find no alternatives hence they just have to use more oil.
The price of oil has been rising but the price of oil complementary products has been falling. For example, there are many energy efficient cars being brought into the market which tend to be cheaper, hence many people buy them. Therefore, the demand for petrol, hence oil increases. Lastly, the advancing technology in the world today has made possible the efficient and economic use of oil (BP, 2011). This is effect makes people to use more oil increasing its demand even more.
How the Increase in Oil Price Affects Demand
How the quantity of oil demanded reacts to the changes in the price of oil (sensitivity) is estimated using its own price elasticity of demand for oil. This is measured as a fraction of the percentage change in the quantity of oil demanded to the percentage change in the price of oil with the assumption that this demand will only be affected by the change in price (Mind Tools). By applying the law of demand and supply, the own price elasticity of demand of oil is always negative. A relatively high price elasticity demand in the short term means that the increase in oil will not affect the quantity demanded very much, in the short term. However, the change in quantity demanded will be significant in the long term if the situation is maintained (Drum, 2011). For example, the price elasticity of demand for the UK is about -0.08% in the short term and -0.64% in the long term (Gateley & Huntington, 2002, p.51). If, let’s assume, the price of oil rose by even 50%, the demand will fall by 4% in the short term but by 32% in the long term. This supports the fact that a relatively high price elasticity will be felt more in the long term.
Effect of Price on Demand
When the price of oil increases considerably, people are forced to find alternative sources of energy such as natural gas, coal, wind power and solar energy. People will also be forced to do more walking, cycling, use public transport or make use of bio-fuels. However, such a switch will need time to take effect as new power stations and windmills will have to be built first. Installation of solar energy power stations will also need time. Therefore, the change (negative) demand for oil will not be felt in the short term but on the long term once all these alternatives are put in place.
If the income levels remained the same yet the oil price increased, the demand for oil will diminish as people will deem too expensive and take up a big portion of their income(). As a result, they will be forced to take cost cutting measures like reducing their travels and lowering thermostats in winter. This will reduce the demand for oil. Additionally, when the price of oil increases, people can switch to more efficient means of using oil like fuel efficient cars, insulation in their places of work and homes which will in turn reduce their usage, hence demand, for oil. Such measures will affect the demand for oil in the long term.
Production Trends of Oil
The production of oil has been rising steadily over the years. The total production of oil has largely been contributed by both the OPEC block of countries and those that are not members. In the mid 1960’s, the total oil production was about 1600 million tonnes. There was a steady increase in the total production until about 1973 where it stabilized at about 2800 million tonnes. There was a slight decrease in production, reaching about 2650 million tonnes in 1975. The production then picked up for the next four years, reaching around 3200 million tonnes in 1979. For about the next three years, the total production went down steadily reaching around 2700 million tons in 1982. The total production remained relatively stable for about three years.
Ever since 1986, the total world production has been increasing steadily over the years. By the year 2000, total production had exceeded 3500 million tons. However, the production has somewhat stabilized at about 3900 million tons from the year 2004 to date.
Relationship between oil price and production
The total production was lowest in 1965, this also happened to be the lowest price of oil. However, the total oil production increased in the increased steadily for about eight years. On the contrary, the price of oil remained relatively low and stable during the same period. This was not to be in around 1973, when the prices shot up sharply. This was also the time that the total world production remained stable and even decreased. This can be attributed to the decreased production of the OPEC block of countries.
The price of oil remained stable for about five years. During this time, the total production had also picked up and was steadily increasing. This scenario was not to be in late 1970’s when the price again rose sharply, peaking in 1980. At this period, the production was steady in its increase. However, at around 1980, the total production started to decrease steadily for about four years. Again, this decrease was caused by the reduced production of OPEC countries. The price also fell steadily although it fell sharply from 1984-1985. From then on, it fluctuated, but not wide margin changes although it decreased generally from the year 1990 reaching a relatively low, less than $0.02 per liter (1960 prices). It rose sharply in 2000 before rising steadily for seven years. The price of oil rose sharply in 2008, its highest ever before it fell down the next year, again sharply. It rose in 2010. However, while the price has been fluctuating since the mid 1980’s, the total oil production was increasing steadily until around 2004 where it has quite stabilized.
From the description of the relationship between oil production and the corresponding prices over the years, there’s no clear pattern between the two as expected and as defined by the law of demand and supply (Ramcharan, 2002). This may be due to the expected oil prices in the future. In general, it is expected that the prices will be high in the future. These expectations make the oil producing countries reluctant to exploit their reserves at the moment as there’s greater incentive in producing in the future. Therefore, current prices won’t affect this resolve. Secondly, the cost of oil production is a limiting factor. The fixed cost in exploiting and producing oil is expensive, but the there are many constraints in varying the production on the short term once the pumping from the field has started. Additionally, expansion of this exploration becomes more expensive and limited due to increasingly smaller oil fields. These two factors make the production of oil relatively steady and quite unresponsive to current price.
Most oil producing countries are politically unstable. These regular bouts of fighting affects the oil production in the countries hence the total production. Therefore, the price changes won’t affect the production that much. The fear of depletion of the oil reserves has also affected the production more than the price (Hubbert, 1956). Speculation of oil by countries where either a country can buy and store oil expecting future price increase or buying oil future so that the country is guaranteed oil in the future also has affected current production of oil (Lombardi and Robays, 2011). In all these cases, the price plays a limited role in the total production of oil.
Why the price of Oil was so high in 2008
The price of oil was at its peak in 2008. This was partly due to the weak US dollar at the time. This is because most oil transactions are done in dollars hence the oil producers will peg their respective currencies to the dollar. Therefore, when the dollar weakens, their revenues decline but costs increase. To offset this imbalance, the OPEC countries raised their prices to preserve their profit margins (Amadeo, 2011).
The year 2008 was also the year the US and the world experienced an economic crisis due to falling stocks and a declining real estate industry. As a result, most investors, fearing the worst, ditched the stock markets and instead bought oil futures which created a speculative bubble. The consequence of this was an unprecedented surge in the oil prices (Amadeo, 2011).
Another factor that contributed to the surge in prices was the instability in Nigeria and Venezuela, which is the ninth largest oil producer in the world (Tristam, 2011). Additionally, there was a real threat of a US/Israeli attack on Iran (Roberts, 2008). These two factors increased the demand for oil as countries built their stocks, fearing disruption. This sudden increase in demand caused the sharp of oil prices.
Why the Price of Oil Fell after July 2008
The escalating oil prices were felt in almost all sectors of the economy. However, the scenario was arrested quickly. The main factor in the fall of the prices was Saudi Arabia’s well timed increase in its production. As a result, there was more oil fuel pumped into the market which helped to reduce the price (Amadeo, 2011).
The recession in 2008 hit the world’s largest economies; The USA and Europe very hard. The economic crisis showed no signs of slowing down (Leigh). Therefore, many of the people in these countries were wary of their spending. The weakening of the dollar also reduced the purchasing power of many Americans (Goldman, 2008). Many took cost cutting measures like driving less. All these factors led to a low demand for oil. This in effect contributed to the falling of the oil prices.
Will the Price of Oil Remain High?
The price of fuel has been relatively high ever since the brief drop in mid June 2008 to early 2009. It has remained high ever since and this scenario will continue to be (Rhodes). This is because political instabilities still persist in the major producers, especially in the Middle East where terrorist activities are still rife. Iraq is not yet peaceful since it was invaded by The USA. The Iran-US relations have yet to cool down and the threat of attacks and counter attacks are still real. The situation in Nigeria has yet to be solved. One of the major oil producers, Libya is going through political turmoil. All these suggest that oil production will continue to be hampered in the near future (Leigh). Therefore, the price will be high unless there’s relative peace in these countries.
Although the demand for oil dropped in 2008, it was mainly due to the recession at the time. Once the economies pick up, people will be more liberalized in their spending hence the demand for oil will continue to be high. This simply means that the price will continue to be high.
The production of oil is largely influenced by OPEC. This block always tends to influence the prices of oil so that its countries generate more revenues. This means that as long as this trend continues, the prices will be high.
Technology has been advancing in terms of fuel production. However, the world is yet to witness an adequate substitute for oil that will make it decrease its reliance on oil as its primary fuel. Therefore, until and when such an alternative is found, the price of oil will just continue to be high.