The End of Cheap Oil

By Rasizade, Alec | Contemporary Review, Autumn 2008 | Go to article overview
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The End of Cheap Oil


Rasizade, Alec, Contemporary Review


THE world oil price has recently crept close to $150 per barrel, more than doubling in one year. By July it had reached $147.27, and though it has fallen back, it remains at a level that, if sustained and eventually augmented, poses a danger of world economic recession. It is clear that the global hydrocarbon market is in the process of rapid transition, and the combination of oil scarcity and accelerating demand (relative to supply) is causing a fundamental shift in this market. Consumers in industrialized countries are still unable to comprehend that we are moving towards a new world, in which they will not have access to the inexpensive oil to which they believe they are entitled, but which is essential to their way of life.

Sudden events, such as a hurricane threatening the Gulf of Mexico and the Russian attack on Georgia, have caused temporary rises in the price of oil. However, until reaching a certain equilibrium at the expense of receding global economic activity, which will balance the price of oil by the law of supply and demand, the fundamental reasons expounded here shall surely push the price of oil on the world market higher and higher.

This dramatic increase in the price of oil can be explained by temporary and fundamental factors. First of all, it is influenced by investors in international capital markets who seek higher profits through investing heavily in oil futures that predict a rise in prices. Oil has become a capital investment and, theoretically, its price could plummet if investors start to predict a decrease in prices. Predictions, however, that take a number of important reasons into consideration, are for a higher oil price in the future. One should include here the worldwide mortgage crisis, which has led to the transfer of further funds from the burst real estate bubble to the oil sector.

The devaluation of the US dollar is another temporary factor and, indeed, the dollar began to rise in August against currencies, such as the British pound and the euro. It is too early to say whether this rise itself is temporary. Oil is priced in US dollars in the world market, and the decrease in its value has made more profitable the exchange of capital from currencies such as the euro or pound sterling to dollars in order to reinvest them in oil futures and options. Therefore, as long as the dollar loses its value, there is going to be a steady increase in the price of oil. It is a vicious circle.

Finally, the accelerating demand for fuel by China and India is another temporary factor. Since 2004, China has become the second-largest oil consumer in the world (after the USA, which consumes 24 per cent of the global production), and its economic growth of around 10 percent a year seems unstoppable. Besides, since China is a prime foreign investment destination and has the largest monetary reserves in the world, its economic development is not expected to stall with further oil price increases, unlike the downturn in the USA.

The price of oil will most likely increase further because the multitude of factors that affect it are not to change in the near future. It is fair to assume, with the currently prevailing oil price trends, that a price of $200 is possible during the coming winter season. On the other hand, this indicates that the era of oil dominance is over as the demand for renewable energy resources (such as solar, wind, biofuel and nuclear power) is now being strongly implemented. (See Contemporary Review Summer, 2008 re biofuels.) The European Union wants biofuels to provide 10 per cent of EU vehicle fuel by 2020. The US Congress has a goal of replacing 15 per cent of gasoline use with alternative fuels by 2017.

The impact of these temporary factors is reversible. But the fundamental reason for the rapid growth in oil prices is its irreversible depletion. Adam Smith's famous 'invisible hand' of the law of supply and demand is relentlessly pushing the petroleum price higher and higher exactly because of its growing scarcity.

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