In the heady month of July 2008 oil skyrocketed to $147 a barrel more than doubling the price of crude over the 12 months to that time. Many thought oil would race past the $150 mark on the way to $200 and to $300 a barrel, and beyond in the imminent year or two ahead.
However, on the heels of such predictions, by mid August 2008, oil has fallen from $147 a barrel (11 July) to $113 (12 August), a large drop across four weeks of 23%. And it may go lower, some predicting to prices well under $110 a barrel.
So we may ask, “What is going on?” And that is indeed a good question that demands an answer.
In this paper we will consider the likely causes for the recent fall back in the price of crude oil and what we can expect for the future trend in oil prices.
There are three main causative factors that may explain the abrupt price drop in crude of the last month.
The stark facts point to a world in the wake of peak oil production which was reached in 2006. Since then world oil production has been on a plateau or in gradual decline. Also at the same time economic growth in many countries around the world was rather spectacular with the Western world hovering around 3% or 4% and China and India, and other less developed countries hovering around a hefty 7% to 10% level. This economic development which many thought was on the way to being universal has a voracious appetite for energy and particularly oil.
The result is that we had worldwide a declining supply of oil, confronting a growing demand for oil, leading to increasing scarcity and the concomitant price hikes. It seems no one, or at least very few, considered at length, the possibility of recession, so soon, that could stem, at least in part, from the spiking prices of oil.
Byron King (2008) suggests:
So we’ve seen quite a tumble [in energy prices], led by declining oil [price]. I’ve said before that oil was climbing too far, too fast. … What seems pretty clear is that at $140, a lot of things in this world just don’t work anymore. Airlines are, obviously, one business not built around highly priced oil. Worldwide, 24 airlines have gone bankrupt so far this year. … But there are other parts of the transport system, the food system and the economy that are [collapsing] with the oil run-up [in price]. Sure, a lot of things don’t work well even with oil at $130, $120 or $110. But that’s not the point. It seems that above $140, the developing world just stops developing. We saw pain at $100 and above. We were beginning to see true demand destruction above $140. So oil [price] pulled back, and perhaps for a while.
Obviously there are limits to the price of oil for an economy to be able to function anything like we have grown accustomed to. Kenneyeth Defeyyes (2008) of Princeton University links oil price to the potential viability of present economies to be sustained. He says, “If we see oil at $300 per barrel, we will be looking out over the smoldering ruins of the world's economy”.
At a price of $130 a barrel oil consumes about 6% of the world’s domestic product (Defeyyes, 2008) and that may appear to be around the upper limit for our present economies to be sustained in a typical way.
But here is the problem, whether our economies like it or not. Oil is increasingly scarce and has been since we passed peak oil production in 2006. Fundamental economics tells us that if we want to keep the price down we have to drastically reduce the demand. And it may be that economic slowing in several economies is heralding a reduction in demand for oil. For example, the economy of the USA is far into one of the worst doldrums ever, and the EU economy may be weakening also. A slackening of the demand for oil, due to economic decline, obviously leads to a price drop.
It may also be that as we are in the early stages of Peak Oil, with demand outstripping supply, we are witnessing wild price swings in a very nervy, anxious market. Again to Defeyyes (2008) to see his comment:
[The] queueing theory predicts that queues behave in a noisy and chaotic manner when demands approach the system capacity. … Instead of energy prices rising to a new stable level, wild price oscillations will result from short-term changes in demand. There will be a tendency, the first time that prices go down, to announce that the crisis is over and oil and gas are now cheap and abundant again.
With this in mind we could expect to see great price volatility but likely in an overall trend of price increases.
But what about the speculators – what role might they play in the present price retreat of oil? It is widely known that many investors have deep positions in the oil market. So, as expected, they headed for the exits en masse as soon as prices started to decline. Their rush to the exits further exacerbated the decline in crude price and prompted other anxious investors to follow. However, investors will bounce back as soon as it is perceived that oil prices have bottomed. There will likely soon be a bounce back in prices (Cobb, 2008) to new record levels, all else being equal.
Some may point to a strengthening of the dollar to explain the shrinking oil prices. However, the strengthening of the dollar by only about 7% over the last month to mid August 2008, does not seem to account for the large drop in the crude price by 23%. And of course, increasing amounts of oil are traded outside the dollar anyway, and so the crude sale price would be less affected by the value of the dollar than it traditionally could have been.
So our future affair with oil may be within an overall trend of declining supply and rising demand, with volatility of prices from the anxiety of the market in which demand surges higher over supply. But the prices will be intermittently buffeted up and down by the fluctuations of economic growth and its levels of fluctuating demand for oil. As investors vie for advantage, they too will aggravate the gyrating price trends.
Cobb, K. (2008), Does Queueing Theory Explain Oil’s Wild Price Swings, Energy Bulletin, 10 August, accessed 12 August 2008, http://www.energybulletin.net/node/46179
Defeyyes, K. (2008), Oil Production, Oil Price, Beyond Oil, 27 May, accessed 12 August 2008, http://www.princeton.edu/hubbert/current-events.html
King, B. (2008), Oil’s Big Run Up and Let Down, Penny Sleuth, 12 August, accessed 13 August 2008, http://www.pennysleuth.com/TodaysSleuth.html