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The Oil Markets
But let’s return to the oil markets. Brock cites three factors which have driven up oil prices. First, there has been accelerating demand, principally but not exclusively from Asia. Despite an increase in price from $10 in 1999 to $140 in 2008, global demand has increased, notwithstanding the recent drop off in US consumption. Second, peak oil has resulted in declining production [see our article on this topic]. Brock believes global oil production peaked about two years ago and has been declining at a rate “more than pessimists predicted.” Mexico’s output has dropped by approximately 30% over the past four years, and there have been production declines from Norway, the North Slope, the North Sea, and Russia. Lastly, a “pathological incentive structure,” which he terms “thugocracy,” is discouraging the exploration and development of new oil fields in ways not previously experienced.
Brock offers the following graphical representation of volatility in the oil markets:
The diagram on the left represents a more stable commodity, such as cotton. On the right is oil, which is unique in that demand and supply are very closely in balance and, more importantly, there is no substitute for oil. We cannot drive our cars and heat our homes without oil, but we can substitute polyester for cotton.
The solid lines represent the supply and demand functions, and the dashed lines represent these functions after a change in either supply or demand. This change is represented by the horizontal arrows in the diagrams. Note that the size of these arrows is the same in both diagrams. The vertical arrows represent the changes in price resulting from the change in supply or demand. Proportionately the same change in supply or demand the oil markets results in a much greater change in price.
The steepness of the supply and demand functions creates the extraordinary price volatility in the oil markets. Economists term this jointly inelastic supply and demand.
We asked Brock why the most recent surge in oil prices seemed to start suddenly in the summer of 2007. He explained that the more meaningful trend began a decade ago, when prices were at $10/barrel and prices have been rising ever since. The surge that began last summer was merely an artifact of the volatility that stems from the steepness of the supply and demand curves.
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