Are Oil Prices Too High?

Michael Giberson

No doubt consumers think oil prices are too high. For the moment I’m wondering if oil prices are too high even for OPEC.

High prices induce a number of adjustments, some of which have long term repercussions. Last time there was an oil price shock at all comparable to the present was around 1979-1981, when world oil prices reached near $100 (in $2008). High prices then helped support continued growth in non-OPEC oil supply (which really got started during the oil crisis of 1973) and spurred substantial consumer interest and investment in energy efficiency. Over time the adjustments contributed to a nearly 20-year long period (roughly 1986-2004) of prices below 1973 prices in real terms.

Additional evidence comes from a paper, “OPEC’s Demand Curve,” by Marc Vatter. Vatter estimates world demand for oil, the effect of oil prices on world income, and non-OPEC supply in order to calculate the net demand for oil faced by OPEC. Vatter suggests that while oil price shocks can be profitable for OPEC – no surprise there – to the extent consumers and non-OPEC suppliers see the price increases as long lasting, they make adjustments which reduce OPEC’s income in the longer term.

Most of the article itself is focused on explaining and defending various statistical assumptions and devices employed in the process of generating his estimates of supply and demand, but even a non-specialist reader may benefit from scanning the article. He sums up his estimates by saying, “we should not expect prices to fall below [$81 a barrel in $2008] for long” given current non-OPEC supply and world oil consumption. Below $81 a barrel, OPEC net income falls.

Vatter doesn’t explicitly peg the upper end of OPEC’s desired oil price range, and possibly the recent economic growth around the world – most obvious in China and India – makes his data analysis over the period 1974 to 2005 less than dispositive, but I would guess a price above $100 in real terms reduces the net present value of long term income for OPEC nations.

If real prices fall below $80 in the next few years and stay below $80 for a while, that will be reason to believe that oil prices now were too high even for OPEC.


2 thoughts on “Are Oil Prices Too High?

  1. I’ve scanned the paper, and it’s interesting, but I do have a few questions:

    1) The evidence is piling up that we’re at or near peak oil production:

    a) OPEC no longer seems to have a lot of spare pumping capacity, unlike the old days.

    b) Oil fields can of course be damaged by overproduction.

    So, those two are geophysics & engineering.
    Then add increased use of oil:

    c) India+China

    d) More subsidies of gasoline use for social reasons inside oil-exporting countries.

    2) Perhaps we’re at/near an inflection point in behavior around oil.

    OPEC folks continue to say “We could increase production, but these high prices are speculation, so maybe we’ll talk about it in the Fall.”

    3) Meanwhile, since the earlier oil shocks, we’ve built a lot of infrastructure dependent on oil. CA alone has 50% more people than it did in 1980, which in practice has meant huge numbers of houses built in spread-out suburbs. While someone can choose to drive less, and get a more efficient car the next time, homes and existing vehicles may well become stranded assets without cheap oil.

    Of course, there has also been a large expansion in air travel, and airplane fleets last longer than cars. [I note Richard Branson is investing in bio-jetfuel ventures.]

    Hence, such things might affect elasticity.

    3) So: the questions are:

    a) Is this a good model across a potential major inflection (if that’s what it is)?

    b) If the prices are too high even for OPEC, and if they can plausibly increase production without causing damage, why aren’t they? [I’ve been in Dhahran, Abu Dhabi, Dubai, working with oil folks, and they didn’t strike me as dumb.]

    c) Is there any difference in oil shocks between those caused by OPEC choice & quotas versus one caused by geophysics?

    d) How much {vehicle fleet, infrastructure} is so dependent on oil that people will increase the percentage of income paid for oil, because they simply can’t adapt very fast, and hence support a higher price?

    Any comments? thanks.

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