Oiling the wheels:

In August 2005 the widely used measure for the price of crude oil, the West Texas Spotrate, had reached $82 per barrel, some 250% higher than in August 2002. Indeed the crude oil price was as low as $11 a barrel as recently as summer 2001. Why has there been such volatility in price? Close examination of demand and supply conditions for oil may give us some clues! Crude oil is refined into a vast number of products via the chemical process of ‘cracking’. However, just three, namely petrol, diesel and fuel oil account for around 75% of oil derivative products and are mainly used in transport and electricity generating activities. Of course, the demand for transport and electricity is closely linked to economic growth; for example, every 1% rise in US national income has been estimated as raising US demand for crude oil by nine-tenths of 1%. Few immediate substitutes exist for crude oil derivatives in transport and energy. Natural gas is perhaps the closest substitute and provides around 25% of total global energy. Estimates suggest that a 1% fall in price of natural gas leads to a three-quarters of 1% fall in demand for crude oil. However, other less obvious substitutes for oil are becoming more important. For example, all types of renewable energy sources (wind, water, sun etc.) are increasingly seen as more environmentally desirable (if more expensive) substitutes for oil in energy production in that they do not emit the carbon dioxide (CO2) and other greenhouse gases which result from using oil-based products. The scientific linkage of these emissions with global warming led to 93 countries (but not the US) having ratified the Kyoto Protocol by 2003, with the developed countries committing themselves to an overall 5% reduction in the recorded 1990 emissions of greenhouse gases by 2012. Climate itself can also influence the demand for oil. The OECD noted that in 2002 the Northern Hemisphere recorded the warmest ever first quarter of the year, and linked this to demand for crude oil from countries in the Northern Hemisphere falling by 1.1 million barrels per year. Whilst the demand for oil is capable of significant shifts, so too is the supply. Around one-third of total supply of crude oil is in the hands of a small group of well-organised oil producing and exporting countries (OPEC). Members of OPEC include Saudi Arabia, Iraq, Iran, Qatar, Libya, Kuwait, United Arab Emirates, Nigeria, Indonesia and Venezuela. These countries meet regularly to decide on the total supply they should collectively produce, seeking to limit the total supply in order to keep the world price of crude oil at a ‘reasonable’ level (said to be around $25 a barrel as recently as 2004 but recent statements suggest a price nearer $40 is in view). Having fixed the total supply, OPEC then allocates a quota to each member state which specifies their maximum oil production in that year.

Questions:

1 a) Discuss some of the factors suggested in the Mini Case Study that might cause an increase in the world demand for oil. b) Now discuss possible reasons for a decrease in the world demand for oil.

2 We have seen that OPEC has tried to restrict the total supply of crude oil from its member countries to keep the world price at a ‘reasonable’ level of around $25 a barrel. Suppose it now aims for a higher world price of around $45 a barrel.

a) How might it achieve this new target? (You could use a diagram here)

 b) What problems might OPEC encounter in trying to achieve this higher oil price?

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