What's Driving the High Cost of Oil?

High commodity prices - including the price of oil - are driving much of the interest in Arctic development.  The high prices would make the exploitation of high cost Arctic resources look more attractive, even if a warming climate didn't reduce those costs.

Figure: FRB Dallas

Why's the price of oil so high?  Will it stay there?

In May the Dallas Federal Reserve Bank published an overview of possible reasons for the current high oil prices: Crude Awakening: Behind the Surge in Oil Prices (Stephen P. A. Brown, Raghav Virmani and Richard Alm, Economic Letter, May 2008).  Brown et al. see:

• high demand from developing countries - especially China and India
• a U.S. economy that accelerated after 2003
• OPEC's success in restricting production
• lags in supply response to price increases
• inelastic short run demand (people don't respond very much to price increases in the short run)
• expectations of increasing prices
• the weakening dollar (since oil is priced in dollars, a weakening dollar reduces the price for consumers and leads them to consume more, and reduces the willingness of oil producers to supply the market)
• political uncertainty in the Middle East, Nigeria, Russia and Venezuela make supplies from those key sources look insecure
• many alternative oil sources (tar sands) may pose more serious concerns about greenhouse gas emissions than oil

What can we expect in the long run:

"What’s the bottom line? Absent supply disruptions, it will be difficult to sustain oil prices above $100 (in 2008 dollars) over the next 10 years."

What about speculation?  There's certainly a market for speculative theories among politicians; they provide someone to blame, and an opportunity for decisive action that doesn't actually appear to require constituents to face up to any serious costs.  They may even be true.  Ian Talley and Gregory Meyer report on Congressional hearings (Oil Speculation Draws Scrutiny, Wall Street Journal, June 24):

...an energy subcommittee investigating the role of speculation in energy prices heard from a panel of energy-market participants who said crude-oil prices would fall with stricter regulation, with retail gasoline that's now over $4 a gallon following suit.

"Prices would probably drop over a reasonably short period of time back to somewhere closer to the marginal production cost of oil, to $65 to $70...and I think gas prices would reflect that in a relatively short order," said Mike Masters, a hedge-fund manager testifying before a Congressional panel probing speculation in the energy markets.

Benchmark light, sweet crude futures on the New York Mercantile Exchange were trading Monday just below $138 a barrel.

Fadel Gheit, managing director and senior oil analyst at Oppenheimer & Co., said prices could come down to a range of $45 to $60 a barrel.

Edward Krapels, a special adviser at the consultancy Energy Security Analysis Inc., said he would expect the retreat from energy markets to be fairly fast.

"I think the amount of speculation is really substantial, [and] I don't think it would take 30 days after the President signed the bill, it would happen more quickly than that...as soon as Congress passed it, commodity funds would withdraw their positions," he said.

Paul Krugman, however, is skeptical: Speculation and Signatures (June 24). Krugman argues that speculation would be characterized by a couple of signatures: accumulation of inventories and futures prices sufficiently higher than spot prices to offset the costs of holding the oil. He doesn't see either of these.  Mark Thoma adds money to the mix: Even More Speculation (Economist's View, June 24).  Thoma pulls together several posts from different authors (including Krugman) into a dialogue on speculation: More Speculation (Economist's View, June 24).