The reasons commonly espoused don't fully explain the more than 10 fold jump in crude oil prices over the last decade. Maybe, oil is pricey because we all have started feeling guilty about consuming it! By Shivshankar Verma

Most commodities follow the simple principles of demand and supply – higher demand leads to higher supply, attracts more producers, which in turn leads to higher supplies and lower prices. Stung by unremunerative prices, suppliers cut back production, prices recover and market reaches equilibrium. Then the cycle starts all over again. This is simple enough to understand and we are all increasingly willing to take this 'free market' behaviour for granted.

However, real life is more complicated than fiction and even textbook economics.

The price history of crude oil has been no different. This most prized of all commodities has gone through many price cycles over the last century, since hydrocarbons emerged as the major energy source. The last major spike in oil prices was in the '70s when Arab countries imposed a production embargo following Israeli attacks on Syria and Egypt. Prices surged even higher in response to the Iranian Revolution and the Iran-Iraq war. Oil cartel OPEC was established even before the '70s oil crisis and paved the way for a definite shift in market influence in favour of the producers.

At the peak of the oil crisis in '70s, there were any number of oil analysts who predicted that the world would soon see a peak in oil output and prices would continue to rise further. Demand was high in major markets while production in the older oilfields in western countries was declining. OPEC members were emerging as the major suppliers, giving the cartel significant pricing power. Geopolitical uncertainties abound in major oil producing regions, creating supply uncertainties. It appeared quite possible that high oil prices were there to stay.

Yet, prices started declining even as as the supply uncertainties dissipated. Though demand continued to rise, the market was awash in oil and prices plummeted. The 'peak oil theory' was promptly discarded. Except for a short rally during the First Gulf War, oil prices remained weak throughout the '80s and '90s. The bottom came at $10 per barrel in the late '90s.

The market bottom triggered another wave of predictions, this time about cheap oil. It was widely accepted that the world was awash in oil and would remain so in the foreseeable future. Technological advancements were expected to reduce demand through the development of alternate energy sources while at the same time supplies were expected to improve with better production technology. Even the respected The Economist magazine predicted oil prices to slip to $5 per barrel! That never happened and prices have been on an upswing ever since.

It's different this time
So, what exactly are the reasons for the more than 10-fold jump in oil prices to $120 per barrel, in just under a decade? Unlike the last surge, we are not threatened with a sharp cut back in oil production. True, the major production regions are volatile and do throw up supply uncertainties every now and then. And yes, Iraqi oil output slipped dramatically and is only now limping back, and will take time to reach full capacity. But, these disruptions hardly cause much of a dent in total global output. It is not as if production suddenly falls by 25 per cent or something as dramatic.

OPEC's influence is also overstated. Despite all the grandstanding by the cartel members, OPEC accounts for less then 40 per cent of total global output. Its 'market interventions' are very mild – mostly adjusting production quotas by up to half a million barrels a day when total production by OPEC countries is currently over 32 million barrels a day – to cause a real change in the supply situation. And since the '70s, the cartel has never threatened an oil embargo – though Hugo Chavez of Venezuela likes to dangle the threat every now and then.

The most talked about reason behind the price surge is the growth in demand, especially in China and India. Even then, the aggregate global demand growth over the last decade is very moderate and cannot fully explain the more than 10-fold jump in prices. Weak economic conditions have actually dented demand growth in the US, which is the major market. US oil consumption actually declined over 1.5 per cent during the first quarter.

Then there is the dollar decline, as another factor thought to be driving up oil prices. If oil prices have gone up in dollar terms, the real impact will be lower if the local currency, say the rupee, appreciated against the dollar. So the oil consuming countries need not be too worried when prices go up, as long as their currencies gain strength. Of course, the American consumers won't benefit from this. The effect is also not very significant for the Chinese, the second biggest oil burners after the Americans, as their currency has seen only a modest appreciation against the dollar.

There is a supply side angle as well to the dollar story. As the dollar has declined, this theory says, oil producers should get higher dollar prices to maintain their revenues. This may be true in the case of producing countries whose currencies have appreciated against the dollar. But, most major producers in the Middle East have their currencies pegged to the dollar. They will feel the pinch only if most of their imports is in non-dollar currencies, like the euro for example, which is not the case.

Refining capacity shortages are also thought to have contributed to the price rise. Tough environmental standards have prevented fresh refining capacity being created in developed countries, especially the US. Shortage of capacity has tightened the supply situation in refined products like petrol and diesel and has pushed up their prices. As the refined products become more remunerative, refiners are willing to pay higher prices for crude oil.

Last of the major reasons used to explain costlier crude oil is increased speculation. Investor and speculator interest in commodities have gone up tremendously in recent years. Though no accurate measures are available, global investments in commodities – including crude oil – is estimated to have jumped more than 10 times in less than 5 years to over $400 billion now. Given the highly liquid market in crude oil futures, a sizeable portion of that money should have gone into oil.

The real reasons
The reasons discussed above, even when considered together, cannot fully explain the sharp surge in oil prices over the last decade. Record prices have not led to a corresponding fall in demand; aggregate global demand has only increased even if the growth rate is declining. Supplies have also not responded to higher prices; aggregate global output has increased more or less in line with demand growth, keeping the supply – demand buffer more or less constant.

The primary reason behind the oil price surge is that consumers across the globe have become used to costly oil and have accepted it as something quite natural to have happened. High energy prices don't surprise us anymore and, consequently, we don't significantly alter our behaviour as consumers by cutting down energy consumption. In other words, we are now increasingly willing to pay the price for the 'luxury' of having an easily available energy source like hydrocarbons.

There are factors that have conditioned us into accepting high energy costs. First is the rapid rise in income levels, so we can afford to pay more for energy. In countries where the average consumer will find 'real' energy prices really painful – like China and India – the government steps in and ease the burden through massive subsidies. For instance, retail petrol prices in India have only about doubled over the last decade when international crude oil prices have increased ten times more.

There could also be 'guilt' factor behind this consumer conditioning. Discourse about global warming and efficient energy use to halt it have become so pervasive that there are few non-believers left in this planet. As a result, some of us have started feeling a tinge of guilt every time we turn the ignition key of our car. Many are willing to buy hybrid vehicles which often cost much more than regular cars, presumably to lessen the guilt.

Businesses which offer us ways to lessen this guilt, by gaining credits through alternate ways so as to reduce our overall carbon footprint, have mushroomed. Many international airlines now offer the option to purchase credits, along with a regular ticket, to 'erase' the carbon footprint caused by our flying. There must be many who are ready to pay for such credits, otherwise the airlines wouldn't offer them.

We all, except those in some Middle East countries where petrol is cheaper than water, now know that hydrocarbons are a scarce resource and the world will soon run out of it. And we all know that we don't have a reliable alternate energy source, not yet. That makes us unconsciously scared of consuming hydrocarbons, but we are not ready to cut down consumption either. Because that involves major changes to our lifestyle, something we are not yet ready for. We compensate for our unwillingness to change our lifestyle through our willingness to pay more for the privilege of consuming hydrocarbons. And that is why crude oil prices are setting records every other day!