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By James Hamilton on Mar 29, 2012 with 3 responses

There’s A Rational Reason for Why Oil Prices Are So High

“There is no rational reason for high oil prices,” writes Ali Naimi, Saudi Arabian Minister of Petroleum and Mineral Resources, in today’s Financial Times. Well, I can think of one– if oil prices were lower, the world would want to consume more than is currently being produced.

The graph below plots total world oil production over the last decade. After growing rapidly in earlier years, production hit a bumpy plateau. In November 2007, just before the U.S. recession began, the world was producing 84.9 million barrels each day, a little less than was produced in the spring of 2005. Although production stagnated, the demand curve continued to shift out, with world GDP growing 5.3% in 2006 and another 5.4% in 2007.

Consumption of petroleum by China alone was 800,000 barrels/day higher in 2007 than it had been in 2005, meaning the rest of the world had to decrease consumption over this period.

Global oil production, thousands of barrels per day, monthly, Jan 1994 to Dec 2011. Includes lease condensate, natural gas plant liquids, other liquids, and refinery processing gain. Data source: EIA.

Growth in oil production resumed after the recession, with world oil production up 2.8% in 2010 over 2009. But world GDP grew 5.1% that year, suggesting demand was once again growing faster than supply. And oil production hit a new snag in 2011, primarily due to disruptions in Libya.

Libyan oil production, thousands of barrels per day, monthly, Jan 1994 to Dec 2011. Includes lease condensate, natural gas plant liquids, other liquids, and refinery processing gain. Data source: EIA.

The data for the above graph only go through December. Production from Libya has increased since then, with some observers anticipating production will be back to 1.4 million b/d by April. But offsetting those gains of the last few months have been shutdowns in places such as Sudan, Syria, and Yemen, which 3 countries had accounted for 1.1 million b/d of production in February of last year.

And Iran’s 4 million b/d is a bigger deal than all of those put together. Petrologistics estimates that boycott efforts have succeeded in reducing Iranian oil exports by 300,000 b/d. Whether that turns out to be the end of the story on curtailment of Iranian shipments, or is only the beginning, remains to be seen.

How much would we have expected the growth in world GDP over the last decade to have increased the quantity of oil demanded if buyers had not faced any increase in price? The answer to this question could be calculated if we knew the income elasticity of demand, which measures the percentage increase in demand that results from a 1% increase in income. A study by NYU Professor Dermot Gately and Stanford Professor Hillard Huntington in 2001 concluded that for 25 OECD countries over 1971-1997, the average income elasticity was 0.55. But for emerging economies and the oil-exporting countries (which are responsible for most of the growth in global GDP over the last decade), the income elasticity is closer to 1.1-1.2.

In the graph below, I plot annual world oil production in blue along with an estimate in red of what demand would have been if the oil price had not risen over the last decade and if one assumes a world income elasticity of 0.75. The reason the actual quantity consumed today is around the blue line rather than the red is because the price today is not the same as it was in 2002.

Blue line: total world oil production, millions of barrels per day, annually, 2002 to 2011. Red line: global oil production in 2002 times (yt/y2002)0.75 where yt denotes global world GDP in year t as reported by IMF. 2011 world GDP growth estimated at 3.9%.

The question is not whether there is a rational reason for high oil prices, but rather whether there is a rational reason the world is not producing 100 million b/d today. And if anyone knows the answer to that question, it should be Saudi Oil Minister Ali Naimi.

This article originally appeared on Econbrowser.

  1. By Optimist on March 30, 2012 at 6:00 pm

    Thanks for the insightfull column, James.

    Surely you jest about the 100 million b/d.

    Given that 100 million b/d is not likely to happen anytime soon, American consumers, like all others, would better reconcile themselves with $100+/b. At least it will encourage us to conserve. And it should stimulate some alternatives, in spite of DOE’s worst efforts.

    And if $100+/b doesn’t smoke out some workable alternatives, we can always move on to $200+/b.

  2. By ben on April 1, 2012 at 7:18 pm

    Dr. Hamilton’s analysis and clarity on the presumed rationality of current pricing is appreciated.  The prospects of 90M b/d production looks promising for 2012.  The hope here is for a measure of stability in the supply and cost of oil and energy supplies in general.   The long-run imbalance between supply and demand poses a challenge for sustaining economic growth at levels capable of meeting the rising expectations of emerging markets let alone those of the world’s industrial powers.    The yawning gap between the relentless growth of global energy demand and that of  production greatly enhances the specter of rising energy costs for the next generation.   The upside of this downside is the salutary impact that higher costs will inevitably have on consumer attitudes toward energy efficiency and the added impetus that higher costs will have in fueling the development of renewable energy sources.   While Dr. Yergin may arguably have his IHS nest to feather in toeing the oil industry line, I suspect that his arguments about a protracted period of dominance for traditional carbon sources isn’t too far off the mark.   I do believe, however, that he underestimates the tipping point on the dynamics of change that will begin remaking the face of energy.  This may be particularly trues as it bears on the cascading effect of distributive models that brings a new-found dynamism to consumer behavior; something that remains under-appreciated by many social scientists, public policymakers and institutional interests in the private sector.  One thing does remain clear, the road ahead promises to be a fascinating one.

    Thanks again for the even-handed analysis. 




  3. By Sarah Bradford on October 3, 2012 at 6:58 pm

    Oil prices are high because we are inefficient and we don’t properly use our energy. There are so many ways we can reduce our energy footprint in this country and yet we still drive monster size trucks, leave the lights on (because electricity is so cheap) and complain about high gas prices. If we Americans could change our lifestyles a bit, we wouldn’t have to focus on foreign oil at ALL! Yes, thats a bit big claim to to make and I’m making it.

    Why don’t we get our homes green certified? . I got my home green certified last year by installing solar power, re-doing the windows and installing a number of gadgets that helps me to automate the energy savings process. For example, I replaced all my old power extension blocks with these PwrUSB smart power strips that lets me schedule a calendar regarding when to turn on and off my garden lights, my computers and media center appliances. Trying to save precious energy and reducing our carbon footprint take will power, efforts and time. But there are so many products that can help us save energy in our everyday lives these days – there shouldn’t be any excuse!

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