Market prices change because supply changes, or demand changes, or both. Starting with the usual suspects—the big, bad oil producers—means investigating supply factors. Given the history of gasoline prices, that's a promising place to start. We know that past cuts in production by the Organization of Petroleum Exporting Countries (OPEC) have significantly impacted the supply, and therefore the price, of oil and gasoline. In fact, during the 1970's, OPEC reductions triggered recessions in many countries. Adding to our suspicions that supply is the culprit, the International Energy Agency (IEA) that advises 26 industrialized countries, recently cut its estimate of oil supply.
The cuts in oil supply estimates are the result of expected drops in production by the big boys, the members of the OPEC oil cartel. They've done it before and they're threatening to do it again. But not everyone is panicking; sometimes—often, actually—OPEC is more talk than action, leaving forecasters in a familiar dilemma.
"The world's oil consumers are scrambling to divine whether the Organization of Petroleum Exporting Countries will follow through next week on a plan to cut [oil] supply." (Dow Jones) The big question is whether the cuts will be significant or effective, and the answer to that question depends on whether all the players are in the game.
"Some cartel officials say that most member states, eager to reap a profit windfall as prices soar, will keep pumping oil flat-out, no matter what OPEC says. The record of the past six months lends support to that scenario. Since September, OPEC has twice called for output reductions but is pumping more oil than before, and far above its official quota." (Dow Jones)
In any cartel there are strong incentives for individual members to not participate in production cuts. (There's big profit to be made if everyone else cuts back enough to raise the price, and you don't.) Beyond the profit incentive to keep pumping, many OPEC members believe that high prices are not good for long-term oil demand because a significant effect of high prices is the innovation and substitution that they cause. People find ways of economizing and new producers enter the marketplace, and in today’s world, it is true that OPEC isn't the only game in town. America's "chief economist," Alan Greenspan, recently voiced the belief, shared by many economic analysts, that OPEC is no longer the juggernaut it once was.
Although OPEC production quotas have been a significant factor in price determination for a third of a century, the story since 1973 has been as much one of the power of markets as of power over markets,[emphasis added] (Reuters)
Bloomberg's web report on rising oil prices notes that other producers are ready and willing to pump oil. "Nations that don't belong to [OPEC] will increase output by 1.27 million barrels a day this year." (Shenk)
While our initial suspicions were understandable, our investigation has produced little to make the case that supply is to blame for our rising gasoline prices. What about demand? Let's look more closely at the IEA announcement.
Crude oil futures in New York rose to the highest in three weeks after the International Energy Agency boosted its forecast for global fuel consumption. Demand for gasoline, diesel and other fuels will rise by 1.7 million barrels a day this year to almost 80.3 million barrels, the biggest gain since 1997, the agency said. It was the sixth straight monthly report to forecast an increase. (Shenk)
Ah-ha! Six months of demand increases sounds a lot more promising than "OPEC might cut production." Again, however, we have to be careful about jumping on the usual suspects. " It turns out that "gas guzzlers" and SUV drivers don't deserve all the blame. And get this—it's even possible to think of rising gas prices as evidence of good news! Really.
While it is true that the economic recovery is causing production, incomes, and the demand for oil to rise, it is also clear that American economic growth is not the key source of increased world demand. The key source—of this bad news / good news scenario—is increased demand for oil in developing countries and, especially, in China.
"Blistering Chinese economic growth is underpinning incremental world oil demand with China's September net crude and oil products at record highs," the International Energy Agency (IEA) said Thursday. The breakneck pace of Chinese economic expansion is rapidly changing the oil demand map.
Huge rises in factory output, a hot summer and growing car ownership in the industrial south propelled China's August oil demand to a record high and the underlying drivers of Chinese oil demand growth showed no signs of abating. (Row)
The good news for China is that economic growth means higher incomes. Richer Chinese mean more refrigerators, more cars, more air conditioning and more energy are demanded. Additionally, as the Chinese economy develops and becomes more industrialized, there is a growing demand for energy for use in production. All contribute to the demand for oil.
So there we are. World oil production is at an all-time high, but so is world demand. Much as we might like to blame producers, the evidence leads us right back to the consumers' side of the market.
We have, of course, seen it before. Gas is expensive; gas is cheap; gas is expensive; gas is cheap. While we tend to notice the ups more than the downs, the reality is that oil and gasoline prices rise and fall all the time. Does that mean we may just need to put off the summer road trip for a couple weeks? Maybe not, this time. As economic growth continues in China and other developing countries, increased demand for oil shows no sign of abating. Many economists, including Federal Reserve Chairman Alan Greenspan, conclude that high prices for oil may be here to stay.
"The rise in six-year oil and (natural) gas futures prices is almost surely going to affect the growth of oil and gas consumption in the United States," Greenspan said in remarks prepared for a conference on energy security. In his speech . . . the Fed chief said the "dramatic rise" in oil and natural gas prices in recent years suggested such elevated prices would prove to be the norm. (Reuters)
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Dow Jones. "OPEC Calls for Oil Cuts But Keeps on Pumping." The Sydney Morning Herald (smh.com.au), March 27, 2004. http://www.smh.com.au/articles/2004/03/26/1079939852017.html?from=storyrhs
Reuters. "Greenspan: High Oil Prices Here to Stay." CNN Money. April 27, 2004. http://money.cnn.com/2004/04/27/news/economy/greenspan.reut/
Row, Sujata. "China oil demand outpaces forecasts, imports rocket." Forbes.com. November 13, 2003.
Shenk, Mark. "N.Y.
Crude Oil Jumps to 3-Week High as Demand Forecast to Rise." Bloomberg.com.
April 12, 2004.
Discussion Questions
After reading the article, individually, discuss the following questions with the members of your small group. Appoint a recorder and a spokesperson, and be prepared to share your conclusions with the class.
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How and why does OPEC change world oil prices?
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Do OPEC production cuts provide incentives for non-OPEC oil-producing countries to increase production, reduce production, or keep their production levels unchanged? How will the actions of the non-OPEC producers affect the price of oil and the effectiveness of the OPEC cartel?
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For a cartel to work effectively, its members must not "cheat" and produce more than their quotas. Why is it likely that members of the cartel will cheat?
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Some OPEC ministers claim that high prices are bad for long term stability of oil markets and oil demand. Provide examples that support or undermine their belief. (Hint: What do they believe happens in the face of high prices?)
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China is a poor country, much of its population getting by on subsistence agriculture. How can China raise oil and gasoline prices in the U.S.?
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Speculate: How will continued growth of the Chinese economy impact the long term growth of the U.S. economy? Is growth of the Chinese economy good news or bad news?
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Economic reasoning allows us to analyze complex questions. While it unfortunately doesn't promise us easy answers, it does help us to identify the costs and benefits we must take into account when confronting uncomfortable questions. From time to time, FTE's "Hot Topics," will put you in the hot seat. How would you answer the uncomfortable question posed by the good news / bad news scenario of Chinese economic growth and world oil prices?
Uncomfortable Question: Suppose you strongly believe that major objectives of world governments should include both reducing poverty and improving the environment. Higher oil prices will cause innovation in new energy sources and conservation of existing resources, thus helping the environment. However, high energy prices disproportionately impact the poor by making energy more expensive and economic growth more difficult. Are the gains to the environment from high fuel prices worth the increased suffering of the world's poor?
Stated another way: Cheaper oil helps to boost development in poor countries, but increased oil exploration, development, and use has adverse environmental impacts. Are the gains to the world's poor from lower fuel prices worth the increased environmental damage?
Teacher Guide to the Discussion Questions
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How and why does OPEC change world oil prices?
Since OPEC accounts for a large portion of world production, any successful reduction in output by OPEC members will reduce the overall quantity supplied of oil. This, in turn, will result in higher prices. Since demand for oil is relatively inelastic (i.e. quantity demanded is not very responsive to changes in price), higher prices mean increased revenues for oil producers.
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Do OPEC production cuts provide incentives for non-OPEC oil-producing countries to increase production, reduce production, or keep their production levels unchanged? How will the actions of the non-OPEC producers affect the price of oil and the effectiveness of the OPEC cartel?
If oil prices rise, the non-OPEC suppliers have an incentive to increase production; they want to sell more at the higher price. As they increase production, the world supply will increase and oil prices will fall, weakening the OPEC cartel.
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For a cartel to work effectively, its members must not "cheat" and produce more than their quotas. Why is it likely that members of the cartel will cheat?
Increased profit provides a very strong incentive to cheat on the cartel agreement and free-ride on the lower production of other members. Suppose everyone else reduces production—and you don't—and the price of oil rises. You are able to sell the same amount of oil as before, but for a higher price, making more profit than the other members of the cartel. Since each member faces this same incentive to cheat, they usually do and the cartel is rendered ineffective.
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Some OPEC ministers claim that high prices are bad for long term stability of oil markets and oil demand. Provide examples that support or undermine their belief. (Hint: What do they believe happens in the face of high prices?)
High prices encourage innovation and substitution. If oil prices are too high people will find substitutes for oil. Students' list of evidence may include: natural gas, solar, wind and nuclear energy, lighter cars, more efficient engines, electric cars, etc. High prices also provide incentives for bearing the cost of discovering and pumping more oil. In the early 1970's, OPEC was a much stronger cartel because the world had not found the vast proven reserves it now has. The price spikes of the 1970s led to exploration of new oil sources and increased production from existing fields.
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China is a poor country, much of its population getting by on subsistence agriculture. How can China raise oil and gasoline prices in the U.S.?
As China develops, its citizens use more energy. Oil is a key source of energy for cars, industry, electrical generation, and petrochemical production. China is the world's most populous country and even a small increase in the income of Chinese citizens dramatically increases the demand for oil and oil products. When, as now, world demand grows faster than world supply, prices rise.
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Speculate: How will continued growth of the Chinese economy impact the long term growth of the U.S. economy? Is growth of the Chinese economy good news or bad news?
It depends. Students will offer a variety of answers. Remind them that despite the possibility that higher oil prices may slow U.S. economic growth, there are positive effects of Chinese economic growth, not the least of which is the increased demand for American goods, services, and resources by Chinese consumers and businesses. Most importantly, the size of the world's economic pie is not fixed, meaning that although it may generate some negative impacts, economic growth in one nation need not occur at the expense of other nations.
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Uncomfortable Question: Suppose you strongly believe that major objectives of world governments should include both reducing poverty and improving the environment. Higher oil prices will cause innovation in new energy sources and conservation of existing resources, thus helping the environment. However, high energy prices disproportionately impact the poor by making energy more expensive and economic growth more difficult. Are the gains to the environment from high fuel prices worth the increased suffering of the world's poor?
There is no correct answer to this question. It should be used as a tool for discussing the opportunity costs that people face as members of society.
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Advanced Question (Not covered in materials): The Federal Government requires that passenger vehicles (on average) satisfy mileage per gallon efficiency requirements. Trucks are not required to satisfy these requirements. Given this information can you explain why auto manufacturers do not offer relatively fuel-efficient station wagons (multi-person passenger cars) that do not meet Federal guidelines for passenger cars, but are more efficient than SUV's? How does this contribute to the demand for gasoline in the U.S.?
Since station wagons do not help auto manufacturers satisfy average fuel efficiency requirements, they will choose not to sell them. Instead, manufacturers will sell SUV's, which are classified as trucks and are not subject to these standards. As a result, the demand for gasoline is higher than it would otherwise be.