Q&A: Why are Oil prices so high?

What has caused oil prices to skyrocket?


In order of influence:

Speculation
Refinery capacity
Western Consumption
Oil Peaking - the world is running out of oil


How have speculators contributed to the price rise?

Hedge funds and investment banks were forced to make huge write-downs with the collapse of the real estate market in the US due to the problems in the sub-prime sector. In order to shore up such losses many speculators moved into the last remaining commodities that could be betted upon - food and oil. A June 2006 US Senate Permanent Subcommittee on Investigations report on "The Role of Market Speculation in rising oil and gas prices" noted, "... there is substantial evidence supporting the conclusion that the large amount of speculation in the current market has significantly increased prices"


Refinery capacity has not been part of any debate on the price of oil, how has this affected oil prices?


Extracting oil out of the ground is one matter, but then using the various elements that crude oil contains requires refining. An oil refinery is an industrial process plant where crude oil is processed and refined into more useful petroleum products, such as gasoline, diesel fuel, heating oil, kerosine, and liquefied petroleum gas.


Oil refineries operate on a 'just-in-time' basis; this has affected the building of new refineries. The huge costs and the long lead times for building them affects decision making and as a result they are built only when they're needed. Both oil and gas prices were relatively low during the 1980's and 1990's; hence very few refineries were built. The surge in prices in the late 1990's was not expected to last hence refinery capacity did not increase - since to finance refineries a 25 year forecast of supply and demand is used. The rise of India and China happened too fast for an increase in refinery capacity; this is why over the past few years there have been refinery bottlenecks, which have contributed to the increased price in refined products such as gasoline, naphtha and jet fuel etc.


The Middle East has the world's largest oil reserves (61%) and pumps 31% of the world's oil every year, but refines only 8% of it.


Although Oil production has continued to increase and although consumption is set to rise, for the last 30 years very few refineries have been built across the world. The US - the world's top consumer of oil has built no new refineries since 1976. The primary motive behind the lack of new refinery new builds is a basic one, a lack of profits for oil companies. In the 1980s and 90s, the fashion for American refineries was not to build more, but to close existing ones. In 2001, Senator Ron Wyden authored a comprehensive report on the state of the US refining industry. He noted that between 1995 and 2001 there were a total of 24 refinery closures in the United States.


What role is global demand playing in the price surge?


At the turn of the 20th century the discovery of oil led to a revolution in lifestyles as a shift occurred from using coal and steam to oil for most machines. Since then with the invention of new technology Western societies have become ever more reliant on oil.


Western consumption and reliance on oil has played a direct role in oil price rises and will continue to have a strong influence on future oil prices. As Western economies are built upon consumption the need for oil based products such as fuel for cars, fuel for air conditioners and fridges, lubricants, plastics and food preparation will continue to rise and affect oil prices unless alternative fuels are discovered.


A lot of blame is being placed upon India and China, how true is this?


It's hard to see what how a doubling in the price of oil in less than a year can be blamed on China and India, the growth in China's oil demand has actually been slowing down. China's first for oil has been known for 15 years whilst India's development received attention when the 21st century began. Their demand for oil would already have been factored into oil prices and in no way explains the sudden price hike.


It is also common practice by the US to blame all global phenomena on Indian and Chinese development from global warming, food prices, metal prices and possibly even terrorism in the future.


Is the world running out of oil?


‘Oil peaking' in simple terms, is when half of all oil production has been consumed thereafter it continually declines. This theory was first proposed in the 1970's and was considered a fringe view at the time. However the end of the 20th century production of oil began to outstrip oil discoveries. The most recent large oil field was discovered in Mexico in 1985, while the majority of today's producers have mature fields that were discovered in the 50's. The world now consumes four times as much oil as is found. Oil companies are spending a fortune on trying to find new oil reserves, but the ones that they find are getting smaller and smaller, and therefore produce less oil.


The peaking of oil has a number of unknowns and these will play a key part in future oil prices, much of the commercially viable oil discoveries have been discovered so it is hard to see where the next big fields will come from.


Although this theory was considered a fringe one in the 1970's it is today a significant factor in determining oil prices, all this means is the demand for oil will increase, at the same time there are huge problems on the supply side.


How much of the problem is Geopolitical and how much is Economic?


There are some economic factors whilst Geopolitical factors will play a central role in energy conflict.


Economically the US dollar has partially caused the current price hike as global oil is priced in dollars. Nations around the world would need to give up their own currency in order to purchase dollars which can then be used to buy Oil. This makes the exchange rate between such a country and the dollar a critical issue as a slight change in the exchange rate will mean a nation may even need to borrow money to purchase an essential commodity such as oil. The current surge in Oil prices lay primarily in speculators moving out of the US housing market and into commodities and with the US printing more and more dollars to inflate its way out of the sub-prime crisis. With oil being priced in dollars, they will continue to fluctuate as more and more dollars work their way onto the markets.


The purchasing power of the dollar can be seen when compared to gold, gold has remained extremely stable over the past century, indeed, over most of history. The price of 100 barrels of oil measured in ounces of gold has remained fairly stable between 5 and 10 ounces of gold for the last 100 years. From just 1973 to 2008, the price of a barrel of oil in US Dollars increased by 3300%. Over the same period the number of ounces of gold required to buy 100 barrels of oil only rose by only 18%. It is not necessarily oil prices that fluctuate but the value of the US dollar, in which oil prices are quoted, that fluctuates. This is why some nations are calling for oil to be priced in Euros'


Geopolitically Iraq which has the worlds 3rd largest oil reserves continues with instability which makes it impossible to bring the nations oil potential to the international markets. Competition for dwindling global supplies of oil between the EU, the US, Japan, China, India and Russia will have a huge impact on future oil prices.


What is the future for energy?


Currently the world population is 6.7 billion and is projected to rise to 8 billion by 2050. This means their will be even more dependence on the worlds swindling energy and with dwindling new oil discoveries this represents a significant challenge for alternative energy sources.


Biofuels has been touted as an alternative however this requires diverting the use of agricultural fields for energy rather then food production. Biofuel technology is still in its early stages and will need 20 years for its required technology to come into the mainstream.


The call for the use of renewable energy is only a discussion in the West and in many cases is used to stifle Chinese development. For all the conferences and meetings on energy use the West has not significantly developed technology which can be make use of renewal energy.


This means the reliance on oil will remain well into the future.