Oil Price Developments – Drivers, Economic Consequences and Policy Responses

by Nadine Pahl (Author) Anne Richter (Author)

Research Paper (undergraduate) 2007 75 Pages

Business economics - Economic Policy


Table of Contents

List of Abbreviations

List of Figures

1 Overview
1.1 Introduction
1.2 Oil as a Non-Renewable Resource
1.3 Suppliers of Oil
1.4 Oil Price Developments from Past to Future

2 Drivers of current High Oil Prices
2.1 Strong World Economic Growth
2.2 Supply Decisions of OPEC and Non-OPEC
2.3 Role of Inventory Standards
2.4 Distributional Bottlenecks
2.5 Geopolitical Tensions and Natural Disasters
2.6 The Role of Commodity Trading
2.7 Scarcity of Oil Resources as Long-Term Driver

3 Economic Effects of High Oil Prices
3.1 Impact on Global Economy
3.1.1 Change in World GDP
3.1.2 Risk of Rising Inflation
3.1.3 Financial Markets
3.2 Quantifying the Impact of Higher Oil Prices on Oil Importing Countries
3.2.1 Economic Impact on Advanced Economies
3.2.2 Economic Impact on Emerging Markets and Developing Countries

4 Possible Policy Responses to Higher Oil Prices
4.1 The Role of Policy Responses
4.2 Monetary Policy
4.3 Fiscal Policy
4.4 Structural Policy

5 Conclusion
5.1 Future Prospects of World Oil Demand
5.2 Résumé

Appendix 1 World Oil Production per Country

Appendix 2 Integral Total Management (ITM) Checklis


List of Abbreviations

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List of Figures

Figure 1: Energy demand by fuel type

Figure 2: Annual global growth in oil demand by sector

Figure 3: Global oil demand per product

Figure 4: Oil demand selected per country

Figure 5: Oil reserves 2005

Figure 6: Proved oil reserves and oil production

Figure 7: World nominal crude oil price chronology (1970-2006)

Figure 8: Selected world oil prices (2005-2007)

Figure 9: Brent crude oil price in $/bbl (1stFebruary to 1stDecember 2007)

Figure 10: Oil prices as of 10th December 2007

Figure 11: World oil demand 1995, 2000 and 2004

Figure 12: Developments in oil consumption (2006-2007)

Figure 13: Global oil demand by region (2005-2007)

Figure 14: Absolute increase in regional oil demand (2000-2030)

Figure 15: Oil production 2005 per thousand barrels daily

Figure 16: WTI forward curve

Figure 17: Relationship between tanker rates and crude oil prices

Figure 18: World VLCC fleet – Age profile as of 2001

Figure 19: Refinery investments (2006-2020)

Figure 20: Oil intensity

Figure 21: OECD macroeconomic indicators in sustained higher oil price case (deviation from base case 2003, in % unless otherwise stated)

Figure 22: OECD inflation rate and average IEA crude oil import (price in 2000 dollars)

Figure 23: Impact of an $80 oil price in 2005 on GDP growth in advanced economies (deviations from the WEO baseline in %)

Figure 24: Oil-importing developing country macroeconomic indicators in sustained higher oil price case after one year by region/country (deviation from base case, in % unless otherwise stated)

Figure 25: Impact of an $80 oil price in 2005 on GDP growth in developing and emerging market net oil importing countries 1/(in %)

Figure 26: Assumed average annual real GDP growth rates 2006-2030

Figure 27: Future world oil demand (2005-2030)

Figure 28: World oil production per country (1996-2005)

1 Overview

1.1 Introduction

Oil prices are an important determinant of global economic performance. Crude Oil prices ranged between $2.50/bbl and $3.00/bbl from 1948 through the end of the 1960s.1 As of this day, the price for crude oil is $89.82/bbl.2 In general, spikes in oil prices are not unusual and are, to some extent, symptomatic of a gradual upward trend in daily oil price volatility. Volatile prices arise from supply and demand that iresult that even small shocks can have large effects on price. But especially within the last few years, the oil price has continuously increased sharply – and to some extent unexpected.

This recent sharp increase in the oil price prompts several questions: Why have oil prices risen? What is the impact on the global economy and on individual countries? How do oil importing countries cope with the higher prices? What are appropriate policy responses to stabilise the economy in face of high oil prices? And last but not least, what role does the Organisation of Petroleum Exporting Countries really play?

To begin with, there is no doubt that the recent increase in oil price is mainly demand driven, combined with historically low excess capacity and heightened concerns about supply disruptions. And even without macroeconomic knowledge, everyone is aware that higher oil prices affect the economy as a whole and all its market participants.

In the following, this paper analyses in detail the current main oil price drivers, their economic consequences and the possible policy responses - always framed by the volatility and uncertainty that characterise the oil market.

1.2 Oil as a Non-Renewable Resource

Oil as a chemical material can be classified in mineral oils and organic oils. This paper concentrates on mineral oil, especially crude oil that has a high carbon and hydrogen content. Organic material was converted through various geochemical processes to mineral oil that today can be found in underground geologic locations, ranging from rocks, to underground traps, to sands.3 Nearly all of the earth's prolific oil basins are identified and most are near-fully explored. Most of the largest oil fields have already been discovered and are being produced. The sources of fossil fuel of about 1,000 billion barrels are limited and will be depleted in around 40 years excluding additional reserves not explored this time.4 In addition, scientists argue that considerable scopes of additionally oil reserves exist. Tough, newly-discovered resources are mostly smaller and more expensive to develop as expected before. These are increasingly offshore, and costs of exploration, development and production are higher than in the Middle East. Crude oil has a great economic value as it is used for the input into various productions and value chains, and for economics it is a non-renewable resource.5 More in detail, oil features classical characteristics of non- renewable resources. It is replaced with an insufficient slow rate that is slower than demand and consumption of it.6 Today, its commercial usage for energy cannot be replaced by other fossil fuels like coal or natural gas or by synthetic oil products. Thus, with a reasonable time horizon oil will maintain its leading position in serving the world’s energy needs. Another important characteristic is that the oil supply is limited relative to demand.7

Oil belongs to the energy market and competes against other fossil fuels like gas and coal as well as against relative new energy resources of hydropower, nuclear power and renewable resources (e.g. wind power or bio fuel). Today, fossil fuels satisfy approximately 90% commercial energy demand of the world. Figure 1 points out the leading position of oil having a current market share of approximately 40%:

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Figure 1: Energy demand by fuel type Source: www.opec.org, 02.12.2007.

Spreading concerns about climate change and security of supply are currently leading o higher interest in nuclear power and especially renewable resources. With the help of technical advances and due to scarcity of fossil fuel, the energy market structure will be modified in future to ensure power supply in the long-run.

Looking closer at the different usage of oil, figure 2 presents an allocation by sectors:

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Figure 2: Annual global growth in oil demand by sector Source: www.opec.org, 02.12.2007.

The transportation sector is the main source of oil demand in the past, today and in future due to a continuous expansion of worldwide mobility. Other demand sources are industry and the demand of households, commerciality and agriculture. Demand for electricity plays a subsidiary role. A further subdivision of demand in clear oil products are dominated by gasoline and gasoil/diesel that accentuate the leading position of the transportation sector:

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Figure 3: Global oil demand per product Source: www.opec.org, 02.12.2007.

As transportation and industry in advanced countries are high, the main oil demanding countries are North America and Western Europe. Nevertheless, developing countries, especially Asian developing countries, are set to account for the current increased demand. Until 2030, their consumption will double from 29 mb/d to 58 mb/d.8

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Figure 4: Oil demand selected per country Source: www.opec.org, 02.12.2007.

1.3 Suppliers of Oil

Supply of oil depends on conventionally reserved crude geological resources of oil. Countries own sovereign territory that includes oil reservoirs. Therefore, the supply of oil can be divided in geographical regions or continents as presented in figure 5:

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Figure 5: Oil reserves 2005

Source: www.globallngonline.com, 05.12.2007.

The Middle East has the sovereign territory of the biggest oil reserves of two-thirds of global proved reserves9 and also possesses the most produced oil deposits.10

There are many different suppliers on the oil market: members of the OPEC, national oil companies, large international oil companies, and small independents. Usually, aggregate oil production is classified in OPEC and individual non-OPEC countries.11 With figure 6 production shares of OPEC and non-OPEC suppliers are pictured:

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Figure 6: Proved oil reserves and oil production Source: OECD (2004), p. 7.

Further detailed information about oil production of countries is given in appendix 1.

In 1960, oil supplier of the Middle East found the Organisation of the Petroleum Exporting Countries (OPEC). “The Organisation of the Petroleum Exporting Countries […] is a permanent, intergovernmental organisation, created at the Baghdad Conference on September 10–14, 1960, by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. The five Founding Members were later joined by nine other Members: Qatar (1961); Indonesia (1962); Socialist Peoples Libyan Arab Jamahiriya (1962); United Arab Emirates (1967); Algeria (1969); Nigeria (1971); Ecuador (1973–1992); Gabon (1975–1994) and Angola (2007).”12 Today, OPEC has its headquarters in Vienna, Austria.13

OPEC co-ordinates and unifies petroleum policies among member countries. The aim is to secure stable prices for petroleum producers and to guarantee efficient, economic and regular supply of petroleum to consuming nations. In addition, financiers who invest in the oil industry should have a fair return on capital.14 According to OPEC’s huge reserves and past incidents of supply shocks15 caused by OPEC, the organisation has essential market power with regard to its market share of 38% in 2003.16

1.4 Oil Price Developments from Past to Future

Crude oil comes in many varieties and qualities, depending on its specific gravity and sulphur content which depend on where it has been pumped from.17 The main differences in the type of extracted crude oil relate to viscosity and sulphur content.18 Viscosity is measured by API gravity that stated how heavy or light the petroleum liquid is compared to water.19 The higher viscous crude oils are called "heavy", whereas those with a lower API figure are classed as “light”.20 Those crude oils with higher sulphur content are called "sour", and the lower sulphurs are “sweet”.21 The heavier and more sour the extracted crude is the more difficult and expensive it turn into usable refined products, so the benchmarks usually chosen are for light, sweet crude oils.22

Prices of crude oil reflect both the product's underlying cost as well as market conditions at all stages of production and distribution. The price of crude oil, the raw material from which petroleum products are made, is established by the supply and demand conditions in the global market.23 The largest markets are in London, New York and Singapore but crude oil and refined products - such as gasoline (petrol) and heating oil - are bought and sold all over the world.24 Crude oil prices are a result of thousands of transactions taking place simultaneously around the world, at all levels of the distribution chain from crude oil producer to individual consumer.25 Crude oil is the world's most actively traded commodity. Thus, oil markets are essentially a global auction - the highest bidder will win the supply.26

To understand the various tables stating oil prices and their development, the knowledge of specific key data given at such tables is essential. There are numerous types of crude oils resulting in numerous crude oil prices. With regard to global crude oil prices, buyers and sellers have found it easier to refer to a limited number of references, or benchmark crude oils, because there are so many different varieties and grades of crude oil.27 The most important five crude oil benchmarks are the following:

- Brent Blend crude oil price
- West Texas Intermediate crude oil price
- New York Mercantile Exchange futures price for crude oil
- Imported Refiner Acquisition Cost (IRAC)
- OPEC basket crude oil price

The two main crude oils which are either traded themselves or whose prices are reflected in other types of crude oil are West Texas Intermediate and Brent (also known as Brent Blend).28

If no other information is given, an oil price appearing in UK and other European media reports refers to the price of a barrel of Brent blend crude oil from the North Sea sold at London's International Petroleum Exchange (IPE).29 Brent Blend crude oil is a combination of crude oil from 15 different oil fields in the North Sea. Brent Blend crude oil is slightly heavier and less sweet than West Texas Intermediate (WTI) crude oil but still light and sweet.30

In the United States, the major benchmark for oil trades and the underlying commodity of the New York Mercantile Exchange’s oil future contracts is the WTI.31 This means that crude oil sales into the US are usually priced in relation to WTI. WTI is a light crude oil that is lighter and even sweeter than Brent crude oil.32 Although WTI has traditionally had a higher price than Brent crude, recently this has contracted and even reversed at times.33

Brent Blend crude oil and West Texas Intermediate crude oil are generally accepted to be the world benchmarks, although sales volume of Brent itself are far below those of, for example, some Saudi Arabian crude oils.34 According to the IPE, Brent is used to price two thirds of the world's internationally traded crude oil supplies.

Another major benchmark is the NYMEX (New York Mercantile Exchange) futures price for crude oil that represents on a per barrel basis the market value of a futures contract to either buy or sell 1,000 barrels of WTI or some other light, sweet crude oil at a specified time.35 Although most NYMEX crude oil contracts are never executed for physical delivery, the NYMEX market supplies important price information to US buyers and sellers of crude oil in the US and around the world, making WTI the benchmark for many different crude oils, especially in the US.36

The Imported Refiner Acquisition Cost (IRAC) is a volume-weighted average price of all crude oils imported into the US over a specified period.37 The US imports more types of crude oil than anywhere else and thought this it may represent the truest world oil price among all published crude oil prices.38 The IRAC is also usually similar to the OPEC basket price, so it too is typically about $6 to $8 per barrel less than the WTI spot price and about $5 to $6 per barrel less than the Brent price.39 But because the IRAC is not reported by EIA (the US Energy Information Administration) until nearly two months after the end of the measured month, it does not particularly timely measure current crude oil prices, so it is often used for longer term analysis.40

The Organisation of Petroleum Exporting Countries (OPEC) has its own reference – the OPEC basket. The OPEC’s basket price is an average of the following seven crude oil prices: Saudi Arabia's Arab Light, The United Arab Emirates' Dubai, Nigeria's Bonny Light, Algeria's Saharan Blend, Indonesia's Minas, Venezuela's Tia Juana Light and Mexico's Isthmus.41 Six of these crude oils are produced by OPEC members while the seventh, Isthmus, is from the non-OPEC country Mexico.

In practice, the price differences between Brent, WTI and the OPEC basket are not large.42 Crude prices also correlate closely with each other. All of the different oil prices are normally stated in $/bbl.

Within the last 32 years, the world nominal crude oil price has almost septublicated from $10/bbl in 1974 to nearly $70/bbl in 2006:

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Figure 7: World nominal crude oil price chronology (1970-2006) Source: See www.eia.doe.gos, 14.12.2007.

Figure 7 shows the development of the world nominal crude oil price. The word nominal is based on the fact that the prices have not been adjusted for inflation. As a result, the prices stated are in "dollars-of-the-day". Furthermore, the prices are volume-weighted average prices of all crude oils imported to the US, as they are measured by the Imported Refiner Acquisition Cost (IRAC). This figure demonstrates clearly the volatility of the oil prices and underlines that from the year 2002 on, oil prices have been continuously and highly increased.

The following figure 8 states the development of three selected oil prices from the near past – 2005 – to today:

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Figure 8: Selected world oil prices (2005-2007) Source: www.worldoil.com, 14.12.2007.

Between 2005 and 2007, the prices for Brent Blend, West Texas Intermediate and Arabian Light crude oil have never fallen under $50/bbl. Especially the prices for Brent Blend and West Texas Intermediate – the two major world benchmarks – are close together. Since February 2007, all three prices have been continuously increased. The following figure 9 underlines this fact by showing the development of the Brent Blend crude oil price from February 2007 to December 2007:

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Figure 9: Brent crude oil price in $/bbl (1 st February to 1 st December 2007) Source: www.newsvote.bbc.co.uk, 13.12.2007.

On 9thDecember 2007, the price for one barrel West Texas Intermediate crude oil was $88.28/bbl. At the same day, the OPEC daily basket was priced with $85.26/bbl, whereas the price for one barrel Brent Blend crude oil was $88.38/bbl. With regard to the year ago – 2006 – all three prices have increased of more than 50%; front runner is the OPEC daily basket with a price increase of 59.75%:

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Figure 10: Oil prices as of 10 th December 2007 Source: www.worldoil.com, 14.12.2007.

The reasons for oil price movements, especially for oil price peaks, are analysed in the following chapter 2 - with special regard to the continuous oil price growth within the last 10 months.

2 Drivers of current High Oil Prices

2.1 Strong World Economic Growth

The price of crude oil is mainly a question of supply and demand. As the quantity of known oil reserves and the capacity for oil extraction cannot changed quickly, the supply is inelastic in the short run, but becomes more elastic in the long run by building new or improve old extraction capacity to increase oil exploration.43 When the volume of oil demanded exceeds the volume of oil supplied, oil prices rise to bring oil consumption in line with supply. As a result, a rapid and unexpected growth in oil demand that exceeds supply capacity leads to an – often high – increase in price.

The relationship between oil demand and price is usually examined within the context of price elasticity of demand, which measures the relationship between the change in quantity of oil demanded and the change in oil price.

Changes in oil prices have a small, and usually insignificant, effect on demand for crude oil, especially in the short run.44 This inelasticity of demand in the short run is based on the fact that buying habits do not respond immediately to changes in prices. Crude oil is used mostly for producing fuel oil and gasoline, both important primary energy sources. That is why it is not possible to reduce oil demand in the short run. Companies for example use fuel oil in engines for the generation of power needed to produce goods. Private oil consumers need gasoline to drive their cars. Especially the transportation sector depends on gasoline to realise daily business. The long- run price elasticity of demand is higher than the short one due to substitution and energy conservation, but the elasticity is still quite low.45 It requires years for consumers to switch to less energy intensive technologies in response to higher prices and it needs large investment in such substitute products.

An important contributor to the recent spike in oil prices has been the unexpectedly strong demand for oil. Strong world economic growth, especially in traditionally large oil-consuming regions, has resulted in strong world oil demand.


1 See www.wtrg.com, 02.12.2007.

2 See www.oil-price.net. 17.12.2007.

3 See www.science.howstuffworks.com, 06.12.2007.

4 See Brook et al. (2004), p. 10.

5 See Mankiw (2004), p. 542.

6 See Fattouh (2007), p. 3.

7 Ibid.

8 See www.opec.org, 02.12.2007.

9 See Brook et al. (2004), p. 6.

10 See www.globallngonline.com, 05.12.2007.

11 See Fattouh (2007), p. 15.

12 www.opec.org, 07.12.2007.

13 See Ibid.

14 Ibid.

15 A supply shock is an event that occurs when oil producers restrict the amount of crude oil they sold on the market.; See Mankiw (2004), p. 794.

16 See Brook et al. (2004), p. 3.

17 See www.news.bbc.co.uk, 13.12.2007.

18 See www.searchwarp.com, 12.12.2007.

19 Ibid.

20 See www.searchwarp.com, 12.12.2007.

21 Ibid.

22 Ibid.

23 See www.eia.doe.gov, 13.12.2007.

24 See www.news.bbc.co.uk, 13.12.2007.

25 See www.eia.doe.gov, 13.12.2007.

26 Ibid.

27 See www.news.bbc.co.uk, 13.12.2007.

28 See www.searchwarp.com, 12.12.2007.

29 See www.news.bbc.co.uk, 13.12.2007.

30 See www.searchwarp.com, 12.12.2007.

31 See www.news.bbc.co.uk, 13.12.2007.

32 See www.searchwarp.com, 12.12.2007.

33 Ibid.

34 See www.news.bbc.co.uk, 13.12.2007.

35 See www.searchwarp.com, 12.12.2007.

36 See www.searchwarp.com, 12.12.2007.

37 Ibid.

38 Ibid.

39 Ibid.

40 Ibid.

41 See www.news.bbc.co.uk, 13.12.2007.

42 Ibid.

43 See Mankiw (2004a), p. 106-107.

44 See www.oxfordenergy.org, 02.12.2007.

45 Ibid.


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Price Developments Drivers Economic Consequences Policy Responses General Economics




Title: Oil Price Developments – Drivers, Economic Consequences and Policy Responses