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The demand for oil has been on the rise due to increasing consumption levels which have been fueled by demand for energy in the transportation, commercial, residential and industrial sectors. In the past two decades, the transport sector has grown in leaps and bounds and has surpassed prior expectations. This is due to the increased demand for personal-use vehicles with high oil-consumption engines. These fuel guzzlers consume 55% of the world’s oil per annum (Hirsch, Bezdek & Wendling, 2005, 3).
Secondly, demand for oil has not only risen in the first-world nations, such as the United States and China, but also in the developing countries. Advancements in the industrial and commercial sectors in developing countries such as India have led to higher oil consumption levels. China’s thriving economy, especially its growing car manufacturing industry, has resulted in an 8% increase in yearly consumption in the last 10 years (Pirog, 2009, 4).
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Finally, the rapid growth in human population has led to increased demand for oil and oil products. Countries have been forced to match their production levels with the growth in population. Therefore, in order to spur growth, they have increased their reliance on oil for the provision of energy to vital sectors. However, fears have arisen on the possibility of an oil peak. If such occurs, world oil production will remain constant. Thus, production will decline, leading to a decline in world economies.
In his study, Cooper (2003, 5) found out that the demand for oil in the short-term is ‘highly price-inelastic.’ Therefore, a large change in the price of oil results in a small change in demand. World oil prices are highly volatile in the short-term. In the past, a single attack on Nigeria’s oil-production sites or the recent attacks in Libya have led to large price increases. This is due to the fact that most countries have little or no reserves to cushion them during short-term shortages. Several sectors, such as transport, cannot be brought to a halt. Hence, countries compete for the available resources, thus driving prices up. On the other hand, in the long-run, oil is relatively price-elastic. High prices for crude oil and oil products spur producers towards higher production levels. In addition, these may prompt new firms to enter the market. Therefore, in the long-term, supply increases. When supply increases, prices reduce since the available demand is sufficiently met.
Several factors affect the price of oil in the short-term and in the long-term. In the short-term, most countries cannot shift to other sources of energy when there is low oil supply. In addition, production cannot be halted altogether. Therefore, key sectors such as transport and industrial sector, must rely on the little oil available, leading to stiff competition. Secondly, both Organization of Petroleum Exporting Countries (OPEC) and non-OPEC countries may limit the supply of global oil with a profit motive. Finally, external shocks may trigger unprecedented shortages in the global market. This leads to a sharp increase in prices due to a higher demand than supply. Hence, in the short-term, the demand curve is highly inelastic.
In the long-term, high prices driven by high demand for oil encourage new investors into the oil sector. Hence, new oils are drilled which leads to an increased oil supply. This lowers the price in the long-term. Secondly, the high prices and demand for oil trigger investment in technology. Thus, faster machines are engineered and efficient wells are drilled at a cheaper cost. This has the effect of lowering prices. Finally, a long period of time allows countries to build up sufficient reserves in order to cater for any unprecedented shortages. Hence, in case of such occurrences, these reserves are used to cover these shortfalls, hence ensuring that prices remain relatively stable. Therefore, in the long-term, demand is relatively elastic (Hamilton, 2008, 15-25).
The World’s Oil production has been on the rise since 1965 except for two occasions in the early 70s and early 80s. In 1973, world oil prices increased rapidly due to the Arab-world oil embargo. In 1979, the Iranian Revolution triggered an oil supply shortage which led to increased prices. In these two circumstances, oil prices spiked upwards over a very short duration yet took a long period to normalize, which led to unprecedented economic recessions. This illustrates the close relationship between demand and price in oil production. In 1980-1985, Saudi Arabia flooded the world market with crude oil which pushed prices below $8 a barrel. This was aimed at curtailing the rising resistance towards OPEC. During the 1990s, oil production gradually increased. However, hostilities in the Middle East such as those instigated against Iraq’s president, Saddam Hussein, the economic recession experienced in South-East Asia, and the 1998-1999 Northern Hemisphere winter led to a large increase in global oil prices. The 21st Century has been the most dramatic period. Although world oil production gradually increased in the early part of the past decade, which stabilized oil prices, the later part of the decade saw large price fluctuations as the oil-producing nations varied production in order to reap maximum benefits (Mckillop, 2008, 2). However, in 2007, a global recession occurred which led to a rapid fall in petroleum prices. As world economies shrank and large international corporations fell, OPEC and non-OPEC countries were forced to cut down on oil production. This reduced world oil supply and triggered a second price hike in 2008. Ever since, oil prices have experienced high volatility. Prices have hit an all time high, which has plunged developing nations into an energy crisis.
Oil prices and production are intertwined. First, the decline in the world reserves has led to the continuous shutdown of several oil production sites. The reserve-to-production ratio, which indicates whether the world can sustain its current production rate, has remained nearly constant in the past decade. Therefore, long-term factors have remained fairly stable and foreseeable implying that short-term factors are responsible for driving oil prices to an all-time high.
Oil producing nations have varied their seasonal output based on cyclic factors such as the dollar’s declining value in comparison to other countries’ currencies, OPEC policies, political upheavals such as the Arab-world revolution, and the rapid changes in the oil industry. In addition, the rapid expansion of developing nations’ economies and the increase in the gross domestic product of countries such as China and India has led to an increased demand for oil.
Therefore, an upward pressure on demand leads to an increase in prices. In an ideal situation, forces of demand and supply would stabilize petroleum and crude oil prices. However, in the last decade, prices have remained highly volatile. Production levels have remained fairly constant as prices soar.
In the past decade, oil prices have been very volatile. However, production has remained fairly constant. This has been attributed to various factors. Whereas demand has been on the rise, OPEC has instructed its members not to increase production. It has allocated quotas to individual member states and instructed them not to surpass these limits. Although non-OPEC countries produce 60% of the world’s oil, this production has peaked. Therefore, whereas demand keeps increasing, these countries are not in a position to increase their annual production (Banks, 2011, 2). In addition, since the 1970s, no major oil reservoirs have been discovered. Therefore, world production levels no longer satisfy demand. Although large reservoirs still exist, they are fully exploited and cannot be used to raise world oil production significantly.
In July 2008, prices hit $145 a barrel, the highest ever price in history (BBC News, 2008). Several factors have been identified as the core drivers of this price surge. First, the fast expanding economies such as China and India drove demand beyond the projected figures. As the price mechanism stipulates, an increase in demand translates to higher prices. Secondly, both Nigeria and Iraq experienced politically-fueled disruptions in their mining fields. Therefore, the world oil supply declined significantly. There were speculations that oil supply would continue to decline. Hence, countries and corporations competed for the available resources, leading to a self-induced shortfall. Thirdly, the global recession partly fueled an increase in fuel prices. The failing real estate and commodity markets led investors into dedicating their funds onto the only stable sector: oil futures. This created a speculative bubble that drove prices upwards. Finally, the decline in the strength of the dollar, partly due to the economic recession, triggered a rise in prices. Most countries peg their currencies against the dollar. When the dollar weakens, oil-exporting countries earn less while their import costs increase. Therefore, in order to earn a profit, OPEC adjusts the price of oil upwards. In 2008, OPEC shifted the price of oil from $70 to $80 before other forces forced a further increase in the price (Rooney, 2008, 2).
In late 2008 and early 2009, the price of oil gradually declined from $145 to below $100. This was attributed to several factors. First, major oil importers, such as the United States, cut back on demand. Hence, major oil exporters were forced to cut back on prices in order to ensure that their products found a sufficient market. Secondly, the end of the United States-Iraq War and the reduction of hostilities between the United States and Iran allowed Middle East nations to concentrate on oil production. Rather than ambiguously raise prices and withhold supply in retaliation, they agreed to resume production and reduce prices. Thirdly, reduced demand in Europe and the speculation over European economic crisis led to large price cuts in oil prices. In order not to loose a significant portion of their market in the long-term, oil producing countries agreed to reduce prices which would otherwise lead to demand destruction, a phenomenon whereby persistent high prices for a sustained duration of time lead to an irreversible downward shift in demand. Finally, the dollar has strengthened against major world currencies. Hence, this has reduced the cost of imports in oil-producing nations while placing them in a position whereby they can reap more from their oil exports (Goldman &Musante, 2008, 3).
The prices for crude oil have been on a steady increase since February 2009. Despite an earlier decline in 2009, when prices hit an all time low of $39 a barrel, prices have surged upwards to reach $113.93 in April this year. However, speculation is rife that prices will remain high. Despite the Libyan War coming to an end, oil production operations will take a considerable time before they resume to their normal state. In addition, rapidly expanding economies such as China are set on expanding further, which will lead to sustained demand for oil products. There is also a high possibility that the United States will engage Iran in a war. Tensions are already high and if negotiations are not held soon enough, oil prices will surge up again. Finally, OPEC member states have embarked on several agendas which aim at stabilizing prices in the short-term. This means that these nations will seek to curb any further price drops (Krauss, 2011, B3).