Commentary: Price of Oil

The real price of oil broke its historical high(0.7 WCU2000) when the nominal price hit US$100 a barrel early in the year. As it continued to surge and approached US$150, ocean- going fishing vessels were held back, flights were cancelled, SUVs were dumped, people switched to public transport, and the world’s stock market crashed. All this is suggesting that at least for the time being, the price of oil at 1 WCU2000 per barrel is probably a short term limit.
There are still people who argue that sky is the limit for crude oil. Many of these cited M.K.Hubbard, who argued that the production of oil would soon hit a peak. Production would then be impossible to expand much further. With world demand rising, the shortfall will translate into price spikes.
There are others who looked at statistical estimates of demand elasticities and suggest that price increases may not check the growth of demand, given the low price elasticity of demand of oil.
These hypotheses directly challenge a basic assumption in economic theory: that higher prices will lead to economizing among consumers and efforts to produce more, and thus price adjustments will bring about real adjustments.
The fact is that as the price elasticity of demand is not a constant. As price increases more and more, one moves up the demand curve, and the price elasticity of demand increases. Moreover, over the longer run, consumers will switch to substitutes, and will change their behavior. The demand curve will shift inwards.
Supply will also rise. There will be more oil exploration, and more effort on alternative energy. The technology for alternative energy will gradually mature and then the demand for oil will decline.
I personally do not believe that there is any chance for the price of oil to hit 1.2 WCU2000 (around USD175 at today’s exchange rates) within the next five years, except in the event of a major conflict. In that event, the price could momentarily breach that, but such a price will still be unsustainable. A major world recession and a gigantic plunge in the real price of oil will be in the cards should this happen.
July 29, 2008