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30 Jun 2008 05:32 pm

What's Causing High Oil Prices?

An illuminating piece by James Surowiecky:

If speculators aren’t at fault, why have oil prices spiked so high? Fundamental reasons aren’t hard to find. Between 2000 and 2007, world demand for petroleum rose by nearly nine million barrels a day, but OPEC has been consistently unable, or unwilling, to significantly increase supply, and production by non-OPEC members has risen by just four million barrels a day. The prospect of military action against Iran, which would disrupt global supply, seems greater than it did a few years ago. And the plunging value of the dollar has meant that the cost of oil has jumped more in the U.S. in the past year than it has in countries with healthier currencies.

But there’s also something else at work, which the oil guru Daniel Yergin calls a “shortage psychology.”

The price of oil—more than that of many other commodities—isn’t based solely on current supply and demand. It’s also based on people’s expectations about future supply and demand, because those expectations determine whether it makes sense for oil producers to sell their oil now or leave it in the ground and sell it later. Currently, the market is assuming that oil will become scarcer, and that global demand will keep rising, especially in rapidly developing countries like China and India. As a result, producers are asking very high prices to pump their oil. Now, it could be that these assumptions are all wrong—that the supply of oil will not be constricted going forward, that concerns about the Middle East are exaggerated, and that higher prices will lead people to cut back on energy consumption, shrinking demand. In that case, oil would turn out to have been hugely overpriced. But that won’t be because of sinister speculators; it will be because oil producers and oil users collectively misread the future.

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