Why Are Oil Prices Going Up?

This is the $64,000 question in today's America. With oil prices having roughly doubled over the past year, and gasoline prices climbing ever higher with them, various conspiracy theories have been invented, and political finger pointing has ensued. But the answer to the spike in oil price is good old fashioned supply and demand numbers. 

According to the U.S. Energy Information Agency, worldwide oil demand exceeded supply in 2007 by roughly 850,000 barrels a day. That's roughly a 3.6 million gallons of oil each day difference between consumption and production. Now, according to the law of supply and demand, whenever demand exceeds supply, the price must rise. This accomplishes two things. It sends a signal to consumers to use less, and it sends a signal to producers to produce more. The combination of both of these effects is to avoid shortages. The good news is, despite all the whining and crying about high gas prices, we haven't seen any gas lines or gas shortages. Thus, the market is doing its job.

Dive a bit deeper into the EIA numbers however, and you will see that worldwide oil production has been plateaued since 2005 at about 84.6 million barrels per day. In 2005, this wasn't much of a problem as oil demand was about a million barrels a day less than supply. By 2006, the intractible growth in demand from the third world (not the US, I'll get to that in a minute) had pushed up demand to the point where it just about equaled supply. That's when gas prices hit the $3/gallon mark here in the U.S.  It was in 2007 that oil demand exceeded supply and saw oil prices really take off. So, the question we have to ask is, with prices at all time highs, why hasn't worldwide oil production increased?

There are three possible answers. One is that we're paying now for the crash in oil prices in the late 90's, which saw prices decline to around $10 a barrel. This decline in oil prices led to decreased investment in exploration and production capacity, and with the increased investments now flowing into this area things will soon be set right.  Another possibility is that geopolitics is to blame, since state-owned oil companies in places like Iran, Venezuela and Mexico have siphoned off the profits from oil sales to fund their governments instead of reinvesting in additional production capacity. The third, and most disturbing possibility, is that world has hit the "Hubbert peak" in which we have used half of all oil that exists in the world and that production will soon begin a decline that we can slow but not stop. As usual, the answer is probably a combination of the three.

Whatever the reason for plateaued production, the easiest way to increase supply is to make the existing supply stretch farther through conservation. Over the past four years, oil demand in the U.S. has increased roughly 3.3% according to the EIA, but the rest of the world has seen an 8.6% jump in demand. What is driving that? Two and a half billion new consumers in India and China wanting a western lifestyle, that's what. But if this run-up in oil prices has proved anything, its that world simply does not have the natural resources using current technologies to make that happen.

The country that can develop those technologies, however, will have a HUGE competitive advantage in the world marketplace, not to mention be in a position to put massive amounts of wealth back in the pockets of their consumers by lowering their energy costs. That is the power of conservation. A far cry from Dick Cheney's statement that conservation was a "personal virtue" but not the basis for an energy policy, conservation is the only way out of this mess. 

And all this campaign rhetoric about drilling in ANWR and the outer Continental Shelf is simply a distraction from the real issue. For one, it would take about 10 years for this new production to come on line and affect the supply-and-demand picture. Secondly, since production from traditional oil fields like West Texas and the North Sea continues to decline, these new oil fields would have to be very large indeed to offset the declines and act as a net positive on worldwide oil supply. And third, this drilling does nothing to slow energy demand which is the real culprit in oil prices. That's where we need to be investing our resources.