The global oil market remains a focal point in macroeconomic discussions because oil is a strategic input into the production process, particularly in emerging markets. Moreover, despite declining oil intensity in the industrialised world, crude oil prices are important because they dictate gasoline prices. Since miles travelled is rather insensitive to the cost of travel in the short-run, it follows that increases in gasoline prices act much like a tax on households.

For oil importing nations in particular, higher gasoline prices imply reduced expenditure on domestic consumption, thereby lowering growth. Higher crude oil prices can also contribute to headline (and possibly core) inflation, increasing the likelihood that the US Federal Reserve (and other central banks) will increase interest rates to rein in core inflation. Such a move would heighten current concerns that the industrialised world will enter a recession in 2009, especially in view of the weak US housing market and jittery global financial markets.

Source: Oil Market Report, International Energy Agency, March 2008.

Why is the price of crude oil increasing?

According to the International Energy Agency (IEA), which represents the crude oil consuming/importing nations, the global crude oil market is projected to be in deficit by approximately 1 million barrels per day in 2008 (Figure 1).

With demand from emerging markets (especially China and India) continuing to grow at a brisk pace, crude oil prices needed to rise simply to balance the market. According to the International Monetary Fund (IMF), the average price of crude oil² was approximately US$71.00 in 2007. Using recent futures contract prices, the IMF now expects average oil prices of US$120 in 2008 and US$133 for 2009.

What are the possible solutions?

One path to lower prices is for the Organisation of the Petroleum Exporting Countries (OPEC) to raise output to accommodate the IEA’s projected demand for 2008. Despite sufficient extraction spare capacity to meet the projected shortfall, OPEC appears reluctant to increase output. It argues that the market is currently well-supplied, and points to excessive short-term speculation in futures markets and shortages in refinery capacity as the main causes of the recent price hikes. Perhaps the most important issue is whether the current oil price increase will trigger a global recession. This is unlikely at least for two reasons.

First, the current increase in oil prices is largely the reflection of robust global growth rather than a 1970’s supply shock. According to the IMF, the global economy has expanded by over 30 percent in real terms since 2003. Crude oil demand depends on the size of the global economy, and supply has struggled to keep up with demand in recent years. In short, what we are experiencing is an “income-shock” rather than a supply-side oil price shock.

Second, the amount of oil needed to produce a unit of output has declined significantly since the 1970s. Compared to the 1970s oil price shocks, it follows that a much larger oil price increase would be required to tip the world into a recession.

Looking forward, if long-dated futures contracts are any indication³, the oil market will remain tight for many years to come. The main reason is that emerging markets are likely to continue growing at a brisk pace, and will soon become “driving nations.” Analysts suggest that the net increase in demand from emerging markets in the next few years will more than offset any increase in global extraction capacity and (depending on OPEC) supply.

Moreover, investment in the oil sector by oil exporting nations is likely to remain inadequate because of restricted access to known reserves to private oil companies and the fact that some of the oil revenue is often diverted to non-oil uses (e.g., oil revenues are an important component of government budgets, and often used to finance the provision of public goods rather than extraction capacity). The long-term solution to the tight oil market is for oil consuming nations to discourage consumption through the use of higher indirect taxes and reduced subsidies on petroleum products. They should also encourage research and development to improve the efficiency of the transportation sector in terms of average miles driven per unit of gasoline.

¹ The spot price of West Texas Intermediate crude oil for August delivery reached US$144.29 in early July..
² Simple average of prices of U.K. Brent, Dubai, and West Texas Intermediate crude oil.
³ Futures prices are known to be relatively poor predictors of future spot prices (compared to using the last known spot price).