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The Oil Price Mirage

August 23, 2005

Tags U.S. EconomyGlobal Economy

The recent run-up in oil prices drew interesting reactions. Some analysts have tried to explain how reductions of crude
demand by refineries can push crude prices up![1] Proving that even corporate economists don’t always remember basic economics, one of them
explained that “[l]ogic and the market are barely on speaking terms these days,”[2] as if the market was anything else than a way to reconcile the participants’ subjective
valuations. An opinion poll at the end of last year already revealed that 40% of Texans thought that corporate greed
was behind high gasoline prices,[3] as if, to paraphrase
Adam Smith, we should expect to obtain our gasoline from the oil merchants’ benevolence instead of their

My chart follows the prices of the benchmark West Texas Intermediate (WTI) from January, 1970, to July, 2005, in
constant July 2005 dollars. (Never mind that the consumer price index, which I use to deflate nominal crude prices, is
only an imperfect measure of inflation; it is useful enough for my purpose of estimating the broad trend in real
prices.) Although real oil prices have been on an upward trend over the past few years, the long-term picture is
different. WTI prices increased from about $20 per barrel in the 1950s to slightly more than $40 after 1973, when the
OPEC cartel cut production in reaction to the Yom Kippur war. A peak of $95 was reached in 1980 in the wake of the
Iranian revolution and of another major production cut by the OPEC cartel.

Real crude prices* January 1970 to July 2005

* West Texas Intermediate in constant (July, 2005) U.S. dollars. SOURCES:
Federal Reserve Bank of St. Louis, and Bureau of Labor Statistics.

After half a dozen years, the cartel collapsed (as economists would expect), because its high prices had reduced
quantity demanded and generated higher production from non-OPEC countries. Between 1973 and today, OPEC’s share of
world production fell from 60% to 40%. After the invasion of Kuwait in August 1990 generated another temporary peak,
oil prices dropped back below their 1970s level.

Thus, if we exclude the spikes caused by geopolitical events, real oil prices have followed a downward trend from
the mid-1970s until the late 1990s.

Now look at the last couple of years. Starting in 2003, crude prices climbed from $30 to around $45 by the end of
2004. Since the beginning of 2005, they have gained another 50%. This may be related to the second war in Iraq and the
general political situation in the Middle East. But note that even after the recent run-up, a barrel of oil costs about
the same as in mid-1982, when prices were going down.

To explain a price increase, we need an increase in demand, a decrease in supply, or both. Supply has recently been
hit by hurricanes and other interruptions. Demand increases have thus generated larger price increases than would
otherwise have been the case. On the demand side, there are many indications that part of the increase has been driven
by speculation. Speculators include motorists who fill up more frequently, home owners who order earlier their winter
supply of heating oil, and refiners, distributors and other intermediaries who try to buy when it costs less.
Professional speculators merely try to anticipate future demand, which depends on the subjective preferences of

Of course, all speculators render a useful service by conveying the market’s evaluation of scarcity. Their activity
also evens out price movements over time: in the case of oil, they buy now, when prices are lower (in their
expectations), in order to sell later, which will bring future prices down. As usual, greed is useful. To repeat what
two Cato economists wrote about the oil industry, let’m gouge![4]

From an economic point of view, higher oil — and oil product — prices are not a problem. They convey useful
information about the perceived scarcity of the resource. Owners of oil fields and other oil assets get rents, but this
is simply a transfer with no special economic significance.

To summarize, oil prices have recently increased because of supply disruptions, and because market participants
believe that the resource is becoming scarcer. Crude oil could be scarcer in the future for a number of reasons: the
political situation in the Middle East and the cost of developing new supplies (like oil sands), on the supply side;
increases in demand, caused by Chinese and Indian growth, on the demand side.

The standard forecast for oil prices is that they will stay high, even if they come down from their peak of mid
August. TD Economics forecasts WTI at $40-50 over the next three to five years, which is representative of the
consensus before the August run-up. Goldman Sachs now forecasts $60.

Yet, the history of the oil industry is replete with exaggerated demand forecasts, pessimistic supply limitations
and sky-high prices. The median forecast of experts polled by the International Energy Workshop in January 1986 was for
crude oil prices of $240 by 2005 (in today’s dollars). Four years earlier, the median forecast for 2000 was $400.

Until his death in 1997, economist Julian Simon predicted a continuous decline in resource prices. In 1980, he made
a famous bet with environmentalist Paul Ehrlich. Simon’s bet was that a $1,000 basket of any five metals chosen by
Ehrlich would be worth less (in constant dollars) 10 years later. Ehrlich lost. In 1990, the value of the basket at
current market prices was down more than 50%. Ehrlich had to send a $576.07 check to Simon, representing the drop in
the basket value. In fact, the prices of all the metals chosen by Ehrlich had fallen.[5]

In his challenging 1981 book The Ultimate Resource, Simon showed that resource prices had generally
decreased over time. The relative price of oil (in terms of other goods) has fallen by perhaps as much as two-thirds
between the 1860s and today. During the same period, the price of oil in terms of salaries has decreased by more than

Simon forecasted that the downward trend in resource prices would continue because, over the long run, the supply of
resources (including oil) increases more than demand. Supply increases because of human ingenuity. Proved world
reserves of oil, which were 762 billion barrels in 1984, are now estimated at 1,189 billion barrels.[6] As for the growth of demand, which normally follows population and
revenue growth, Simon argued that it would be dampened by new technologies that reduce the use of oil (like lighter
cars), and eventually by new materials. The value of petroleum as a proportion of finished products will continue to
decrease. And contrary to Malthusian fears, population growth will spur the potential for inventions.

In the past few years, however, many resource prices — exemplified by copper — have gone up. As the saying goes,
forecasting is risky, especially with regard to the future. Prices change because people change their minds. But we
know the broad interacting factors in oil prices: political uncertainty in the Middle East, increased demand from
rapidly developing countries (assuming that their growth is not stopped by their states), and the usual innovation
spirit and entrepreneurship of man. We should just make sure that politics interfere as little as possible with the
last factor.

 Pierre Lemieux is an economist at the Department of Management Sciences of the Université
du Québec in Outaouais, a research fellow at the Independent Institute, and a Western Standard columnist. A
shorter version of this article appeared in the Financial Post (Toronto), August 19, 2005. E-mail:
Comment on the blog

[1] See, “In Jittery Oil Markets, Outages
at Refineries Pack Bigger Punch,” Wall Street Journal, August 12, 2005, p. A3.

[2] Quoted in
“Observers Denounce Oil’s Flight as ‘Logic-Defying’,”, Financial Post,

August 9, 2005, p. 1.

[3] “Survey Indicates
More See ‘Greed’ in Oil Industry,” Knight Ridder Tribune Business News, August 12, 2005, p.

[4] Jerry Taylor and
Peter VanDoren, Let ’Em Gouge: A
Defense of Price Gouging
Cato Institute, April 1, 2003.

[6] BP, 
Statistical Review of World Energy 2005,
London, 2005.

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