Oil prices are sinking towards $100 (Rs4,440) a barrel. But robust global demand suggests the price may not decline much more. Even at $100, the black stuff is still much more expensive than in 2007 and above the realistic long-term equilibrium price. That’s unhealthy for the global economy.
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In the first half of 2008, oil production outside the Organization of the Petroleum Exporting Countries (Opec) declined by 330,000 barrels per day (bpd), while demand increased by more than one million bpd owing to fast global growth and low interest rates. Helped along by speculation, benchmark oil prices spiked to more than $140 per barrel in early July.
Since then, oil market supply conditions have eased, with Opec production up by 350,000 bpd and non-Opec producers adding 550,000 bpd. With global economic growth also looking less robust, oil prices have slumped.
But even as they near $100, the cost of oil remains 50% above the 2007 average. As a result, demand can be expected to remain subdued. In the US, the 35% petrol price increase between the summers of 2007 and 2008 accompanied a demand decline of 4.35%. That suggests a price elasticity of demand approaching 15%.
Price elasticity in poorer countries should be higher. On the other hand, price controls in several countries and high flat-rate taxes in Europe and Japan reduce the sensitivity of demand to underlying oil prices.
Overall, this dynamic should prevent oil prices remaining much above $100 for a prolonged period. But continued economic growth, particularly in China, should absorb the modest supply increases expected in the next year or so, preventing the price from dropping much further, either, for the time being.
For the world economy, this is bad news. The long-term equilibrium price of oil is probably around $60 per barrel, at which deep-sea exploration and extraction from tar sands remain very profitable. A price well above that level increases costs in non-oil producing countries while providing windfall profits to oil producers.
Such windfalls may benefit oil producing nations’ citizens, but they are also used by countries such as Iran, Russia and Venezuela to back up aggressive and potentially destabilizing foreign policies. As a result, oil priced well above its long-term equilibrium level leaves the world as a whole both worse off and less stable.