A Rational Reason for High Oil Prices

“There is no rational reason for high oil prices,” writes Ali Naimi, Saudi Arabian Minister of Petroleum and Mineral Resources, in yesterday’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.

A rational reason for high oil prices

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About James D. Hamilton 244 Articles

James D. Hamilton is Professor of Economics at the University of California, San Diego.

Visit: Econbrowser

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