[OPE] The "elasticity" of world oil demand...

From: Jurriaan Bendien (adsl675281@tiscali.nl)
Date: Thu Jul 10 2008 - 20:41:30 EDT

(...) The world is still well supplied with crude, and production will rise steadily in the next few years. (...) So why have prices doubled in the space of a year despite supply remaining relatively steady? The simple reason is that people are still willing to buy oil, even at $140/b. According to the International Energy Agency (IEA), demand is still rising, albeit more slowly than forecast. This suggests that demand for oil isn't as "elastic" as we thought. The "elasticity" of oil demand-its responsiveness to changes in the oil price-is complicated. If you drive to work, a 30p rise in the cost of a litre of petrol (say another 12 a week) is tough-but most people in Britain aren't yet quitting jobs that require a commute. Lorry drivers are complaining, but they will eventually pass the extra bill on to their customers. Airlines are suffering and air travel is getting pricier, but people are still flying. The world's transport sector depends so heavily on oil products-and the global economy so heavily on the transport of goods-that switching off demand isn't easy. (...)  But if demand from the world's biggest oil consumer is falling and more production is expected, why are prices in the futures market still stuck at $140/b?

The answer lies in two distortions of the market. 

The first stems from hot money swamping the world's commodity exchanges. Investment funds, bruised by falling stocks and a weak dollar, see oil as a hedge. In June, a near-$10/b jump in prices in one day-almost unheard of before-was triggered not by any physical shortage, but by "short-buying" the market. Investors had bet on a falling price by selling oil they didn't own-so when news of more dollar weakness triggered a rise, they scrambled to cover their positions. According to some estimates, there are now up to three times as many "paper barrels" traded in New York and London as there are physical barrels of oil supplied to the world each day. Investment banks have jumped on the speculative bandwagon, at the same time as some of them have forecast the market; cresting as high as $200/b, in the case of Goldman Sachs. As Stephen Schork, editor of an influential oil market newsletter, says: "higher prices have become self-fulfilling prophecies." The bull run now defies rational explanation.

The second distortion is fuel subsidies, which rob high prices of their economic impact. (...) Half of the world's countries have subsidies, says Morgan Stanley, an investment bank, and 22 per cent of the planet's gasoline consumption is subsidised. Some countries in the Asia Pacific region, home to the most egregious subsidies, have begun to scrap them. But China hasn't-thus putting a floor underneath the international oil price. China's state-owned refiners run a loss because of these subsidies, but Beijing can afford them because its enormous trade surplus ($13.4bn in March) continues to add to its collosal foreign currency reserves (now almost $1.7 trillion). As long as the world keeps buying Chinese goods, China can keep buying oil and selling it cheaply to its citizens. A world recession, helped along by high oil prices in the west, could end that cycle. 

Yet removing price caps, fears Beijing, could exacerbate inflation, which is already at an 11-year high. Moreover, the Chinese advance a "moral" argument to support subsidies. Western countries got rich off cheap fuel, so why can't China too? The answer, says the IMF, is that fuel subsidies help the better off-the ones living in air-conditioned flats and driving gas-guzzling cars-more than the poor. (...) But it will be difficult to convince consumers in poor countries. A farmer in rural China is unlikely to agree that he should pay more for his fuel so the American driver can fuel up his Dodge Ram more cheaply. In Burma, violence broke out last year after the government lifted price caps. Free markets are great when they yield low prices-but cheaper oil for rich westerners could mean pricier fuel for the world's poor. An end to subsidies in China would send the oil speculators in New York into a selling frenzy. Until then, the investors are betting that China and other developing countries will put their citizens' need for cheap fuel ahead of energy-thirsty westerners. Something in the market will give at some point, but it might be a question of who is beggared first: the rich west or developing Asia. http://www.prospect-magazine.co.uk/article_details.php?id=10270

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