Get used to it

Oil prices still aren’t high enough By Derek Brower, journalist YOU SPEND just over £1 ($1.95) and you can transport four or five people, and their luggage, about seven miles across the countryside. In those terms a litre of petrol in the UK, where gasoline prices are among the highest in the world, is good value, allowing remarkable mobility, in comfort, and all for the price of a bottle of Coca-Cola. It’s not quite that simple, of course, because despite the claims of its advertisers Coca-Cola doesn’t make the world go around. Oil does. Look around you: everything you see depends, in some way or another, on the petroleum industry. Anything that needed to be transported, anything that is made of plastic or other synthetic materials — it all relies on the extraction of hydrocarbons and their conversion into energy.

That’s why governments in consumer countries are suddenly in a panic about oil prices. Since the beginning of the year, barely a week has passed when traders in New York and London haven’t set new record highs for the price of oil. Last week, the Nymex contract for prompt delivery of light sweet crude oil traded over $135 a barrel, the latest record high and double the price of last year. Voters are complaining, asking their governments to ease the burden by subsidising prices.There is a lot of guff being written to explain the rise. High prices aren’t the result of a shortage of oil, despite what some believe. Nowhere in the major consuming economies is oil failing to reach the consumer. Nor are they a result of Opec’s manipulation of the market, despite what UK Prime Minister Gordon Brown thinks. There are tankers in the Persian Gulf loaded with Iranian crude that no-one wants. And Saudi Arabia, considered to be the swing producer and major force of Opec, knows that putting another 0.5m barrels a day of heavy crude onto the market would do nothing to soften prices — refiners, whose capacity is already maxed out, don’t need or want more heavy stuff, and that is the extra capacity that Opec has available.Nor is the bull run in the market a result of Peak Oil. Yes, the world will eventually run out of oil if it keeps extracting it at present rates, but that moment isn’t imminent. And, in any case, the theory has been around for decades — the market has had plenty of time to price it into the cost of crude.Instead, price rises are a result of three forces. The first is the weakness of the dollar. As it sinks, producers increase the price of their crude to compensate. As the Fed has intervened to rescue the American economy, by slashing interest rates, the softer dollar has forced oil prices higher. The second is demand from Asia and other booming economies in the developing world, where the rise in prices has had little impact, yet, on demand. China’s economic growth has already made it the second largest consumer of oil and the International Energy Agency estimates that about 60% of the rise in demand to 2030 will come from Asia. Government subsidies there continue to insulate consumers from the true cost of crude.The third factor is the flow of hot money into commodities, especially oil. The involvement of the “speculators”, as Opec calls them, in the bull run of the last few years has created a bubble in prices comparable to the internet and property bubbles. Both of them exploded and the commodity bubble will too, the only uncertainty being when it will happen.Goldman Sachs, itself one of the market speculators with a large position in the market, says a “super-spike” could see prices rise to $200 a barrel within the next year. With so much hot money, the market has become volatile, reacting to news about short-term supply worries, like bombs in Nigeria, with jumps of several dollars in a single day. Two-hundred-dollar oil now looks plausible.But the real reason that oil prices have risen is because they were too cheap – and still are. When prices were £10 a barrel in the late 1990s, companies cut their budgets. Exploration tailed off and new projects were put on the shelf. Cheap oil also boosted demand. That combination — rising demand and a decade of little new production – laid the foundation of the market’s bull run.But the biggest problem created by cheap oil in the 1990s is that alternative energies haven’t emerged to challenge oil’s dominance. The spectre of climate change has given some impetus to renewable energy – though all the wind farms in the world won’t replace the internal combustion engine, or its need for oil.Nor has the market bull run of the last few years truly affected demand – or boosted alternatives to oil. The last oil price shocks, in the 1970s and early 1980s, forced energy consumers drastically to reduce their use of oil. A legacy of that is that OECD countries use oil at about a quarter of the intensity they used it before those price crises. Overall consumption of oil may be higher now, but Western economies are that much less dependent on oil.The “elasticity of demand” for oil – an economist’s term meaning how high prices can go before people stop buying the stuff – now means that despite the doubling of prices, people are still buying it. Until they stop buying oil, there is no reason for prices to fall. Analysts estimate that the “marginal” price for oil – the price it must pass for production to be viable – is now at $80 a barrel, which gives a natural floor to prices. But otherwise, the price of oil isn’t set by sellers, it is set by buyers. And in this market, people are still buying oil at $135 a barrel.That means oil isn’t expensive. It’s just costlier than it was when it was cheap. If people don’t like the price of oil, they have a way of striking back: by not buying it. Only when some people start doing that will the market discover where the marginal price of oil is at the top end – in other words, how expensive oil can get before people stop buying it.So if you think the world’s addiction to oil creates problems (pollution, climate change, resource wars, and so on), then you should hope prices continue to rise. The costlier a litre of gasoline becomes, the more people will cycle to work, and the more people cycle to work, the more the car companies will work to make their vehicles more efficient. Forget targets to solve climate change and reduce carbon, rising energy prices have the power to affect consumer patterns more profoundly than any pleading from politicians.That’s a hard sell for governments who are worried about inflation and angry voters who see their energy bills rising by the week. But subsidising prices — through reduced petrol taxes or through gasoline tax holidays — will only make the problem worse. Consumers set energy prices by their willingness to buy the commodity. As long as they continue to do so, the market has every reason to suppose that the price of oil is in balance.In a market, “expensive” is a relative term and only applies when a product is beyond the means of the buyer. The market hasn’t discovered yet at what price oil is truly expensive. It isn’t producers who are responsible for record crude prices. It is you and I and anyone else still willing to buy oil, or anything that depends on it, at the same rate that we were buying it when oil prices were $10 a barrel.