The Rise in the Price of Oil
http://www.becker-posner-blog.com/
Gary S. Becker[1]
The run-up in the world price of oil during
the past several years, and especially the rapid climb during the last few
weeks to over $120 per barrel, has fueled predictions that the price will reach
$200 a barrel in the rather near future. Such predictions are not based on much
analysis, and mainly just extrapolate this sharp upward trend in oil prices
into the future. The price of oil in "real" terms (i.e., relative to
general prices) will not reach $200 in this time frame without either terrorist
or other attacks that destroy major oil-producing facilities, or huge taxes on
oil consumption. I try to explain why in the following.
The two previous sharp increases in the
world price of oil, in 1973-4 and 1980-81, were due to supply disruptions. The
first one was the result of the formation of OPEC that led to output
restrictions by members of this cartel, while the later one was due to the
Iran-Iraq war that curtailed petroleum production in these two countries.
Although the world price of petroleum rose by a lot in all three episodes,
worldwide oil production went down in the two earlier ones, while production
has risen during the current price boom. The present boom in oil prices has
been mainly driven by increases in demand from the rapidly growing developing
nations, especially China, India, and Brazil, although output growth in the US
and European have added to world demand, and speculation on potential future
price increases also contributed to the increased price of oil. To be sure,
supply problems in Nigeria, Venezuela, Russia, and other major oil-producing
states have
contributed to accelerations in the oil price increases at times during the
current boom.
Note the contrast between the major causes
of the current explosions in oil and food prices. Although the sharply rising
prices of different commodities are often lumped together, increases in the
prices of corn and other foods have in larger part come from the supply side
rather than from demand. The main supply culprits in the market for foods have
been the diversion of corn acreage to the production of ethanol, and the
increased cost of fertilizers and chemicals used in food production due to the
rise in the price of oil (see my discussion of rising food prices on April 13
and 17).
The rapid growth of world oil prices during
1973-74 and 1980-81 contributed in a significant way to the world recessions
during those years. Yet even though world oil prices in real terms are now
above the prices in 1981, the previous peak in oil prices, and despite the
sharp run-up in prices during the past couple of years, the world economy has
not (yet!) been pushed into recession. One reason for the difference is that
unlike the previous episodes, the current price rises have slowed rather than
eliminated the boom in world output. Another difference from the previous
episodes is that the share of oil and other energy inputs in GDP is down by a
lot in the developed world since 1980, especially in Japanand Europe, but also
in the US.
Of course, even with energy's smaller role
in the production of output, any rise in oil prices to over $200 a barrel in
the next few years would have serious disruptive effects on the world economy.
To many persons who have commented on this prospect, such a high oil price
seems plausible, given the expected continuation of the rapid growth in the GDP
of China, India, Brazil, and other major developing countries. For
the evidence is rather strong that the short run response of both the supply of
and the demand for oil to price increases is rather small. The small elasticity
of both the supply and demand for oil explains why the moderate reductions in
world oil supply during the earlier price spikes, and the moderate increase in
world demand during the current price boom, produced such large increases in
price.
However, the long run response to price
increases of both the demand and supply for oil and other energy inputs is
considerable. For example, given enough time to adjust, families react to much
higher gasoline prices by purchasing cars, such as hybrids and compacts, that
use less gasoline per mile driven. They also substitute trains and other public
transportation for driving to work and for leisure purposes. High energy
prices, and hence the opportunity for large profits, induce entrepreneurs to
work more aggressively to find fuel-efficient technologies, including the use
of batteries as a replacement for the internal combustion engine.
Clearly, given high enough oil prices, many
ways are available to increase the supply of petroleum, Explorations for
additional supplies will be extended deeper into oceans and other remote places
because the high cost of extracting oil from these sources would be offset by
the high energy prices. Usable petroleum is also already being extracted from
oil sands and oil shale, and high and rising oil prices will speed up and
extend this process. The reserves of tar sands in Canadaand Venezuelaare huge;
indeed, Canadais getting much of its oil production from
this source. Oil shale is also abundant in several places, including the United
States, and while extraction of petroleum from
shale is expensive and complicated, the high prices have induced some countries
to start doing this.
Rising prices of oil and other energy inputs
will eventually be controlled by new technologies that greatly economize on the
use of these inputs. Increased supplies of oil and other energy sources that
become
profitable to exploit only with prolonged high prices will also push these
prices back.
Posted by becker at May 11, 2008, 09:11
PM
Why We Should Be Rooting for $200
per Barrel of Oil
Richard A. Posner[2]
As Becker explains, we cannot predict the
future price of oil. But it is unlikely to rise in the foreseeable future to
$200 a barrel, especially if we think in inflation-adjusted terms. Oil prices
in real terms have fluctuated a great deal. In December 2007 dollars the price
of oil was below $20 in 1946, above $100 in 1979, and only about $10 a recently
as 1998. High prices affect both demand and supply; the recent price peaks have
already reduced demand for gasoline in the United Statesand increased efforts
to discover and
exploit new oil fields. The United Stateshas large untapped oil reserves both
offshore and in Alaska, and there are many other untapped reserves
elsewhere in the world. Supply is responding to the high price of oil and will
respond more. If Iraqever stabilizes, its output of oil will
increase. Were the world price of oil to rise to a level close to $200, both
demand and (with a lag) supply would respond. Oil trapped in sand and shale--a
potentially very large supply--would become economical. In the longer run, very
high oil prices will further stimulate the development of alternative fuels.
Major political or natural catastrophes
could of course alter the picture. Middle eastern oil supplies are vulnerable
to the ever-present threat of war in that region, and the oil industries of
Venezuela, Nigeria, and possibly even Saudi Arabiaare vulnerable to political
unrest, civil
war, or terrorism.
I would like to see the price of oil rise to
$200, despite the worldwide recession that would probably result, provided that
it rises as a result of heavy taxes on oil or (better) carbon emissions. The
taxes would jump start the development of clean fuels, and the financial impact
on consumers could be buffered by returning a portion of the tax revenues in
the form of income tax credits. That would not reduce the effect of the taxes
on the demand for oil or the incentives to develop alternative fuels, because
the marginal cost (the production and distribution cost plus the tax) of oil to
consumers would not be affected. Higher oil prices are necessary to check
global warming, reduce traffic congestion, and reduce dependence on foreign
oil, so much of which is produced by countries that are either unstable or
hostile to the United States. Heavy taxes on oil would reduce not only
the amount of oil we import but also the revenue per barrel of the oil
exporting nations, so there would be a double negative effect on those
countries' oil revenues: they would sell less oil and earn less per unit sold.
The reason for the latter effect is the upward-sloping supply curve for oil.
Suppose the first million barrels of oil can be produced at a cost of $1 per
barrel and the second million at $2 per barrel. If total demand is one million
barrels, the suppliers break even: they have revenues of $1 million and costs
of $1 million. If total demand is two million barrels, the suppliers have
revenues of $4 million (because the price of all barrels is determined by the
price that the marginal purchaser is willing to pay) but costs of only $3
million ($1 million for the first million barrels, $2 million of the second).
The lower the price of oil received by the oil producers (that is, the price
net of tax), the lower their net income.
Unfortunately I cannot see a confluence of
political forces that would make heavy taxes on oil feasible. We seem to be
experiencing a democratic failure, in which long-term problems simply cannot be
addressed.
Posted by Richard
Posner at at May 11, 2008, 09:04
PM
________________________________
[1]Gary S. Becker is University Professor,
Department of Economics & Sociology and Professor, Graduate School of
Business, The University of Chicago. He
was the recipient of the 1992 Nobel Prize in economics.
[2]Richard A. Posner is Judge, United StatesSeventh Circuit Court of Appeals
and Senior
Lecturer, University of Chicago Law School
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