What's Driving Oil Prices?

Richard G. Anderson, Jason J. Buol

An earlier version of this article appeared in the January 2005 edition of Regional Economist, another publication of the St. Louis Fed.

The price of oil reached record dollar levels during 2004. (See the figure.) And because oil is such an important commodity, economists want to better understand the factors that influence its price. This article will answer to what extent supply and demand, speculation and other factors have affected current oil prices.

Demand

The International Energy Agency reported in August 2004 that world oil demand was growing at its fastest rate in 16 years. As developing countries have expanded their economies, they also have increased their oil consumption. Two countries that have significantly increased their oil demand are China and India.

China became the second largest consumer of oil in the world in 2003, currently demanding approximately 5.56 million barrels of oil per day (bbl/d). Estimates by the U.S. Energy Information Administration (EIA) predict that China will double its consumption of oil in the next 20 years, reaching 12.8 million bbl/d by 2025.

India has experienced 40 percent growth in oil demand-increasing its oil demand from 1.6 million bbl/d in 1995 to 2.2 million bbl/d in 2003. And the EIA predicts India will continue to expand and consume more oil, reaching 2.8 million bbl/d by 2010.

Supply

Compounding the demand factor, several oil-supplying countries have endured turmoil that has limited their production capabilities. The most obvious country is Iraq.

Since the start of the war, Iraq's oil production has been uncertain at best. A central reason is the continued violence and sabotage of facilities. Throughout 2004, insurgents were able to destroy pipelines and oil production facilities and disrupt a steady flow of oil coming from the country. Until these attacks are stopped, it is unlikely that Iraq will be seen as a reliable supplier of oil to the world market.

Another oil country with political turmoil is Venezuela. Political problems were exacerbated with a nationwide strike in December 2002. The strike, which lasted until early 2003, led to significant reductions in the country's GDP and oil production. Since that time, production has been returning to levels seen before the strike; however, there are still reasons to doubt the country's progress. Political uncertainty continued when President Hugo Chavez survived a recall vote to remove him from power in 2004.

Speculation

Many people, including Acting OPEC Secretary General Maizar Rahman and Federal Reserve Chairman Alan Greenspan, believe that speculation has driven up the cost of oil by $10 to $15. Greenspan testified in September 2004 before the House Budget Committee that one possible source of higher prices was speculators, who influenced prices by taking larger positions in crude oil futures. This theory suggests that more active trading was taking place before and during the period when oil prices were reaching record nominal levels. A cursory examination of petroleum futures volume data in the Wall Street Journal demonstrates that the volume of trades was up during this time period, which indicates that enhanced speculation did contribute to increasing oil prices.

Other Factors

Because oil prices are so volatile, we also need to examine other variables that can affect prices. The recent series of hurricanes disrupted the flow of oil into the United States and damaged oil facilities. Oil refineries also shut down periodically for maintenance, regulatory changes and other reasons. But neither of these factors will have a long-term impact. As hurricane damage is repaired and oil refineries are reopened, production will resume.

What our research indicates is that significant changes in oil supply and demand behavior will continue to impact the price of oil. As China, India and other developing countries expand their economies, they will likely follow the same pattern of sharply increasing their demand for energy.

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