That’s the title of my latest research paper. Here’s the summary from the paper’s introduction.
How would one go about explaining what oil prices have been doing and predicting where
they might be headed next? This paper explores three broad ways one might approach this.
The first is a statistical investigation of the basic correlations in the historical data. The
second is to look at the predictions of economic theory as to how oil prices should behave
over time. The third is to examine in detail the fundamental determinants and prospects
for demand and supply. Reconciling the conclusions drawn from these different perspectives
is an interesting intellectual challenge, and necessary if we are to claim to understand what
is going on.
In terms of statistical regularities, the paper notes that changes in the real price of oil
have historically tended to be (1) permanent, (2) difficult to predict, and (3) governed by
very different regimes at different points in time.
From the perspective of economic theory, we review three separate restrictions on the
time path of crude oil prices that should all hold in equilibrium. The first of these arises from
storage arbitrage, the second from financial futures contracts, and the third from the fact
that oil is a depletable resource. We also discuss whether commodity futures speculation
by investors with no direct role in the supply or demand for oil itself could be regarded as
a separate force influencing oil prices.
In terms of the determinants of demand, we note that the price elasticity of demand
is challenging to measure but appears to be quite low and to have decreased in the most
recent data. Income elasticity is easier to estimate, and is near unity for countries in an
early stage of development but substantially less than one in recent U.S. data. On the
supply side, we note problems with interpreting OPEC as a traditional cartel and with
cataloging intermediate-term supply prospects despite the very long development lead times
in the industry. We also relate the challenge of depletion to the past and possible future
geographic distribution of production.
Our overall conclusion is that the low price-elasticity of short-run demand and supply,
the vulnerability of supplies to disruptions, and the peak in U.S. oil production account for
the broad behavior of oil prices over 1970-1997. Although the traditional economic theory
of exhaustible resources does not fit in an obvious way into this historical account, the
profound change in demand coming from the newly industrialized countries and recognition
of the finiteness of this resource offers a plausible explanation for more recent developments.
In other words, the scarcity rent may have been negligible for previous generations but is
now becoming significant.
You can read the entire paper here. Comments welcome from all.