Return to Economics index
Published: June 2012
Regional instability has led to high oil prices, forcing world leaders to reconsider strategies to stabilize prices. Martin Vladimirov examines the dynamics of oil prices affecting the pursuit of long-term solutions for sustainable development.
HIGH FUEL PRICES are to nobody’s liking. This is especially true in an election year like 2012, with all politicians vying for voter attention and support. Under the pressure of public discontent with the current economic situation, populist forces are on the rise. The governments of Germany and France have started discussions about a ceiling for gas prices. In March, President Obama ventured that there is enough oil on the world market, and the new sanctions against Iran would not push prices up. American confidence is based on the belief that the U.S. and the member-states of the International Energy Agency (IEA) possess the necessary tools to keep the oil price stable, and that energy independence (in the form of unconventional oil and gas) is an attainable goal. Yet such hopes could prove illusory.
Source: Financial Times Statistical Record
Oil prices have their own, often counterintuitive, logic. There are five main factors which have led to the rise in the oil price during the last two years: an unexpected economic boom in the Asian developing countries amid economic slump in the West, low spare production capacity of the Organization of the Petroleum Exporting Countries (OPEC) member states, geopolitical risk in the Middle East and Africa, oil reserve balances in the high income countries of the Organization for Economic Co-operation and Development (OECD), and intense speculation in the financial markets. The last factor played an important role in the sudden rise of the oil price to almost 150 USD per barrel in the summer of 2008. Amid low economic growth and the danger of a new recession in the Eurozone, speculators are keeping prices high, buying long-call options betting on a future price increase. Therefore, even if there is no material ground for a price increase, investor expectations keep prices high in a self-fulfilling prophecy.
In May of last year, Rex Tillerson, the CEO of Exxon-Mobile, said that the oil price must have been between 60 USD and 70 USD per barrel due to shrinking energy consumption. Yet the reason why it is over 110 USD is actually due to geopolitical risk and financial speculations. Political instability has permeated the world in the last 15 months. Several Arab dictators close to the West were swept away by revolutions in the Middle East. The civil war in Libya led to a North Atlantic Treaty Organization (NATO)’s military intervention, and there is deliberation to intervene to put an end to the bloodshed in Syria. Meanwhile the pressure on Iran’s nuclear program and the European Union’ (EU)’s new sanctions against Iranian oil exports have significantly raised the prospects of a regional war with the participation of Israel and even the United States. There are also fears that the Strait of Hormuz in the Persian Gulf—through which 20% of the world traded oil passes—may be closed off by the Iranian navy in case of a war with Israel. Experts believe the EU sanctions that will enter into force on July 1st this year will cut world oil supply by 2.2 million barrels per day (mbd). This is only 2.5% of the total world supply calculated in March, but it would lead to a 25-30 USD spike in the oil price.
So, what can world leaders do in order to stabilize prices? In order to bring prices down, the world needs to find a sustainable solution to the conflict with Iran. Teheran came back to the negotiation table in the end of April, which had an immediate effect on the Brent Crude price benchmark ( which used to price two-thirds of the world’s traded oil). The past month saw the crude price fall from 125 USD to under 110 USD per barrel. However, unless concrete proposals for a solution to the Iranian crisis are taken at the next round of negotiations in Baghdad beginning at the end of May, the oil price will climb back to 120 USD in the coming summer once the EU sanctions kick in. Recent intelligence reports point out that Iran is closer to a nuclear arms capability, which leaves little time for Israel to take military action against uranium enrichment facilities in Iran. Nonetheless, world leaders have other tools to keep prices down in the short term. Two different methods have typically been used. After the oil embargo by OPEC in 1973, the advanced economies, including the United States, United Kingdom, and France, guaranteed the creation of strategic petroleum reserves (deposited at the IEA), which are to be used in the case of a sudden drop in world supply. Today they amount to 1,6 billion barrels, which could sustain world oil consumption for around 17 days. The use of the strategic reserves works successfully in periods of momentary crises such as the cut in production in the Gulf of Mexico after hurricane Katrina in 2005 or the NATO military intervention in Libya last year. However, the oil reserves are insufficient for a long-term reduction in oil supply from the Persian Gulf. Even if combined with the industrial reserves of the OECD countries, consumption levels could not be met for more than two months.
Another well-known method for controlling prices is an increase in oil production amongst the OPEC members. At the end of March, the second largest oil producer in the world, Saudi Arabia, produced a record 9.9 mbd. The oil kingdom confirmed that, if needed, it can fully cover the Iranian share of the world oil supply by using its spare production capacity of 2.5 million barrels. However, according to several energy specialists, this is little more than a bluff on the part of Saudi Arabia. Their skepticism is based on the fact that when oil prices were skyrocketing in 2006, 2007 and 2008, the production capacity of the OPEC countries rose too slowly to compensate for the increasing demand. Speculation in financial markets is driven by the inadequacy of the strategic reserves combined with the fact that oil producers need more time and investment to increase their production capacity. This creates a vicious circle that distorts the dynamics of supply and demand.
Another important tool that the politicians might employ in order to influence gas prices is to decrease the tax burden on fuel, since the price of gasoline at gas stations increases significantly as the oil price surges. This applies particularly to the EU, where taxes on fossil fuels have a large influence on the price mechanism. European countries face not only increasing oil prices, but also eco-taxes, high value added tax, and the fuel tax that can make up as much as 45-50% of the overall price of gas. While in the U.S. the oil price determines gasoline prices for up to 60%, in Europe it is 40% on average. This makes EU’s gas prices almost twice as high and has had a very dramatic impact on European economic recovery.
Despite the gloomy picture, the long-term predictions for the oil price are not bearish. The major players both on the consuming and producing sides are aware that prices are abnormally high. There is a strong belief in the market and that prices will go down in the next three to five years. The economic boom in China is likely to subside in the coming decade, while both unconventional sources of oil and a more permanent energy shift towards natural gas and renewable energy are expected to bring the long term oil price well under 100 USD. Meanwhile there is geopolitical instability in the Middle East and a reserve buffer for energy consumption; however, we are bound to remain victims of price volatilities. Unless countries take steps to decrease dependence on expensive energy sources, find new alternatives to oil in the transport sector, develop the production of renewable energy, and improve energy efficiency, the price of oil will remain a contentious issue during elections.