Anchorage Daily News

Are we seeing another speculative bubble or are crude oil prices merely responding to fundamental changes in worldwide demand? Are U.S. crude oil prices likely to drop sharply, say back to the levels of 2003, when the average was about $31 per barrel, or will worldwide demand keep prices at or near record levels?

Here are some facts. You be the judge as to whether or not changes in supply and demand since 2003 really justify crude oil prices of $130 per barrel or more.

Fact 1: Chinese and Indian demand has been blamed for much of the increase. According to the U.S. Department of Energy, China's demand for crude oil rose from 5.58 million barrels per day in 2003 to 7.58 million barrels per day in 2007. Even though that represents a 36 percent increase in Chinese demand, it amounts to only a 2.5 percent increase in world demand. India's demand is less than one-half that of China's.

If we can believe historical estimates of the relationship between supply, demand and price, the rise in Chinese and Indian demand accounts for at most a 30 percent increase from 2003's $31 price. That comes to about $9 per barrel.

Fact 2: Again according to the U.S. Department of Energy, the excess of world crude oil supply over demand rose from zero in 2003 to 790,000 barrels per day in 2005. Since 2005 things have changed. During 2007 worldwide demand exceeded supply, reaching just over 1.1 million barrels per day. Worldwide excess demand of 1.1 million barrels per day amounts to 1.3 percent of 2007 world supply and is less than the increase in Chinese demand since 2003.

Is it possible that worldwide excess demand of 1.3 percent could trigger a 132 percent rise in the U.S. price from $31 per barrel in 2003 to $72 per barrel in 2007 and on to $130 plus in 2008? The answer is yes but only if the short- to medium-term demand for crude oil is substantially less price responsive than the estimates that I have seen would suggest.

Fact 3: Some of the rise in U.S. crude oil prices can be blamed on the decline in the dollar. If the dollar had remained at its January 2003 level relative to the euro and everything else had proceeded as it has, the July 15, 2008 U.S. price of crude oil would have been just over $90 per barrel, even allowing for some speculative increase, rather than the $138 per barrel that was reported by the U.S. Department of Energy. In other words, something like $35 per barrel can be blamed on the decline in the dollar relative to the euro.

Putting all of this together suggests that at most one-half of the increase through mid-July 2008 in the U.S. price of crude oil can be explained by historical supply and demand relationships and the decline in the dollar. If we are willing to accept that historical relationships are not too grossly out of date to be informative, we are left with the following two-part question. Where has the other one-half of the increase come from and how do we explain the surge to over $140 per barrel earlier this month?

A growing consensus places the blame on highly leveraged commodity speculators who need pony up only a small fraction of the purchase price (as little as 6 percent) to buy a contract on the New York Mercantile Exchange. If that is true, then in the absence of speculation the equilibrium U.S. price of crude oil should have been between $75 and $80 per barrel in mid-July of this year and not $138 per barrel.

A final word of caution: markets tend to swing back and forth. Even if the true equilibrium price is $75 per barrel there is little reason to expect an orderly progression to that level. It is not out of the question that prices might drop well below $75 before settling in.

David M. Reaume is a Washington state-based economist who was based for many years in Juneau. His opinion column appears every fourth Sunday.

ADVERTISEMENT