What leads to a plunge or spike in global oil prices?

The fall in global oil prices over the past six or so months has got me worried. Not because I don’t fancy lower prices which effectively translate into high real income for households; but because all those who prefer cheaper fuel have been converted into students of Sam Cook’s school of economics.

Actually, Cook was never an economist but a popular American musician who once sang about “what a wonderful world this can be”.

If you are the type that finds solace in those who anchor their expectations on fuel prices remaining low then you have Mr Cook’s attitude.
But then Mr Cook makes another revealing confession: “Don’t know much about history,” he croons.

There is one problem that those who believe in this confession must confront; when it comes to oil prices, history matters.

In March 1999, The Economist magazine had an interesting cover story which simply declared that we were Drowning in Oil!

At that point the price of oil was in the $40 (Sh3,660) to $43 (Sh3,930) per barrel range. The core argument then was that the “world is awash with the stuff, and it is likely to remain so”.

On the heels of The Economist’s story was the Newsweek’s April 2009 edition which screamed: Cheap Oil Forever! Of course oil was never cheap forever.

The fall of the oil price then, from a high of about $130 (Sh11,880) per barrel, was as drastic as the one we have recently witnessed.

Interestingly, the rise was equally rapid. Within one year the price had shot up to over $85 (Sh7,770) per barrel before surpassing the $120 (Sh10,968) mark by April 2011. What is happening today? Is it a repeat scenario?

In an attempt to answer these questions, I will present three hypotheses. The first is the M King Hubbert theory, also referred to as the “peak oil” account.

The theory states that based on geological considerations oil production is characterised by three phases — rapid rise, peak and terminal decline.

Hubbert predicted in the 1970s that world oil production would peak in the mid 1980s and decline to 35 million barrels by 2000. The peak theory engendered expectations that the world was running out of oil.

The consistent rise in oil prices from a low of about $10 (Sh914) per barrel in January 1999 to a record $147 (Sh13,436) in July 2008 seems vindicate Herbert’s theory.

But there is a small problem here: Hubbert’s projection is off the mark.

Historical data indicates that in 1980 global oil production was at 59 million barrels per day, rising to its current level of over 75 million.

So the data rejects the “peak oil” explanation for all the episodes of drastic price rise — where prices rose from about $40 (Sh3,660) per barrel to about $120 (Sh10,970) by April 2011.

This leads to the second hypothesis, the so-called fundamentals theory. Those subscribing to this theory, market fundamentalists, argue that the rise and fall of oil prices is primarily an outcome of demand and supply conditions. The theory is credible but not exhaustive.

I argue so on the persuasion of a 2009 paper; Causes and Consequences of the Oil Price Shocks of 2007 – 2008 by economist James Hamilton, published by the Brookings papers on Economic Activity.

The paper says that the price responsiveness of demand and supply of oil is very low. This means that a small change in demand requires large changes in prices so as to equate supply with demand.

So when demand softens as it did with the onset of the global economic meltdown in 2008, large price swings are expected.

The demand responsiveness arising from the global economic performance may have increased in the recent past. Indeed the extent to which oil prices respond to economic slowdowns has progressively increased from the 1970s.

A number of studies show that such changes arise from at least three points. One, the influence of oil cartel Opec has been gradually withered by other players including US shale oil extraction.

Two, while in the 1970s major oil producers used to enter into contract pricing, the market has moved largely into spot selling; so price responsiveness was obviously slower than now.

Three, futures markets for oil were more limited or underdeveloped in the 1970s than they are now.

This means that opportunities to take speculative market positions on future oil price were more limited then than they are now. This means that market fundamentalists only tell us part of the story.

The third hypothesis is speculation. If the global economy was in recession between December 2008 and April 2011, what can explain the price increase over that period as earlier observed?

Part of the answer lies with the fact that over the past decade there has been substantial financilisation of the oil market.

A 1976 paper by economist Rudiger Dornbusch titled Expectations and Exchange Rate Dynamics argues that while financial markets adjust instantaneously, goods markets adjust slowly.

But not oil, I argue. This means that in the event of drastic market movements prices of oil may undershoot or overshoot a given range considered suitable for consumers without hurting producers.

In the absence of a formal model to determine such equilibrium level, those who keenly watch the market and use indicators such as market valuation of major oil companies and what some Opec mandarins consider to be “fair” put that range at $75 (Sh6,855) per barrel to $90 (Sh8,226) per barrel.

If indeed the market undershot this time around, then the latest IMF commodity price forecast indicates that we are now turning the corner. Let’s savour this moment while it lasts. It may not be forever.

Osoro is the director of Kenya Bankers Association’s Centre for Research on Financial Markets and Policy.