Without doubt, economic factors and political events play an important
role in the change of crude oil prices. However, I believe that
economic factors have the upper hand in determining long-term
trends in oil prices, while political events related to the stability
of the Middle East and the Arabian Gulf region take the lead in
the short run. Indeed, a study of economic factors alone, without
an attempt to understand the complexity of political events, is
insufficient to explain and predict oil price trends in both the
short and long terms.
Oil traders study regional and world economic factors of crude
oil proven reserves, the production, transportation, and total
demand in world markets. In the end, they accept market determination
of oil prices. In studying price data over time, I have listed
the prices of Arabian light crude in Table 1 and adjusted
the figures for inflation.
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The figures in the last column demonstrate that the 1995 price
of oil in real terms and the 1996 figure were less than half the
price in 1974, when the first big jump in oil prices occurred.
Following the second oil shock, the price peaked at $21.24 in
1972 prices. Afterwards, there was a steady decline until the
trend was reversed in 1996, due mainly to the steady increase
in world demand for oil. Economists attempt to explain crude oil
prices in order to forecast them in both short and long terms.
However, no theory has thus far been able to use economic variables
in a model that can accurately predict future oil prices. This
article will focus on two models - a mainstream one and one by
this author.
Because of inherent competition among oil-producing nations, some
economists concluded in 1972 that the price of crude oil was bound
to drop to the level of its marginal cost. However, there are
three major criticisms of this theory. First, the marginal cost
of a barrel of crude oil differs not only from one country to
another, but also from one well to another. The model did not
offer any criteria for what they may have chosen as the figure
for marginal cost in general. Second, when applying new technology,
the marginal cost was drastically reduced - as in the case of
North Sea oil. Third, if such a theory were to be valid, the price
of crude would never have reached the high levels it did in 1974
and 1980, but should have kept sliding downward to whatever they
meant by marginal cost.
In an attempt to explain the dynamics of oil pricing in the long
run, I presented a study at Oxford University in November, 1982,
which was later published. In applying economic theory, I introduced
a new statistical demand curve, which differentiated between upward
and downward trends in oil prices. I argued that a small rise
in price from its low pre- 1973 levels would not have an appreciable
impact on the quantity demanded, as the demand could be highly
inelastic. However, as oil prices substantially increase, the
quantity demanded must eventually be reduced. Meanwhile, both
production and exploration will increase, as prices keep their
upward trend.
In economic terms, the inelasticity of demand must be reduced
with a continuous increase in price. As prices rise, the demand
curve becomes concave to the origin. If prices fall in response
to a glut, for whatever reasons, a conventional downward-sloping
demand curve could occur. The model showed the dynamics of the
interaction between oil prices and the quantity demanded over
time. Excessive demand and a constant search for market equilibrium
reflect an upward trend. A glut in a politically stable market
reflects a downward turn. My model is limited, however, because
it does not address short run fluctuations. Moreover, there is
no way to have complete market data or to quantify all political
developments or events.
The effects of political events on the region's stability differ
when they are expected or unexpected. Expected situations are
factored out in the price of crude oil in the spot and future
markets in world trade. Consider, for example, recent events in
Iraq. An analysis of crude oil prices during the Security Council
debate over the international oil embargo on Iraq, and on how
and when to allow the country to sell 700,000 barrels per day
to purchase food and medicine and to pay for repatriation under
UN terms, shows that the market was not affected when the Resolution
was agreed upon last August. In resorting to political risk analysis,
oil traders were certain that Security Council Resolution 986
on Iraq's behalf would eventually be adopted. Hence, they factored
out the partial entry of Iraqi crude oil into oil markets even
before the resolution was adopted. When political events occur
suddenly, however, crude oil prices rise immediately. An analysis
of short-term fluctuations of these prices shows a strong correlation
between the region's political instability and the prices.
On September 3, the US attacked targets in southern Iraq after
Saddam Hussein attacked the Kurds in northern Iraq. The price
of West Texas intermediate crude jumped by $1.20 - an increase
of approximately 5%. Since the US bombing was limited, the tension
subsided somewhat. The oil price dropped back by $0.17 on September4.
The same day, Palestinian President Yasser Arafat shook hands
for the first time with Israeli Prime Minister Benjamin Netanyahu
at Eretz Crossing, a checkpoint between the Gaza Strip and Israel.
This act gave hope to some circles for a possible revival of the
Middle East Peace Process. On September IO, indications of Iraq's
rebuilding its air defenses, which had been partially destroyed
by the US attack, pushed the price back up by $0.40 - an opposite
turn.
When Iraq fired a missile at an American military aircraft, the
US prepared for an air strike against Iraq, although there were
no casualties. The price of oil then jumped by $0.60 to $24.75
a barrel on September 11-the highest in five years. On September
12, the price rose again by $0.20. The next day, Iraq announced
it would not fire any more missiles against US military
aircraft. Although the situation was temporarily contained, the
US moved more weapons and personnel to the region. On September
13, the price expectedly decreased by $0.42. On September 16,
President Clinton announced that he sought no confrontation with
Saddam Hussein. While the rhetoric cooled, rumors circulated in
the New York Mercantile Exchange that the US had urged Saudi Arabia
to boost oil production, should US-Iraqi tensions disrupt oil
deliveries. The price of oil dropped by $1.35 the same day. However,
on the 17Lh, 3500 additional US troops were ordered to Kuwait,
and the price of oil increased by $0.15. So the story continues.
This 14-day swing of political tension and oil prices is not a
special case. Since the 1956 Suez crisis, the pattern of tensions'
affecting the price of oil is the same because of the relative
importance of the Middle East. The region sits on 660 billion
barrels of oil, representing almost two-thirds of proven oil reserves.
It produces 20 million barrels per day (approximately 33%
of world production) and has 45% of world trade in oil.
The relationship between oil prices ("P") and political
tensions ("T") -in the region in general, and the Gulf
in particular-is summarized in Table 2 (see above) by
the "+" sign when "T" increases, and the sign
when it decreases. Hypothetically, if the situation worsens and
lasts longer than expected, oil traders would leave factored out
in the price the pattern of political turmoil and left daily fluctuations
to economic consideration.
Although political tensions with Iraq have somewhat subsided,
the price of oil may not decline substantially, even to the level
before September 3. The reason is the continuous surge in world
demand for oil - for various factors. First, growth in the real
domestic product (GDP) of advanced industrial countries has steadily
increased. For example, the increase in the European Union's GDP
amounted to 0.49% in the first quarter of 1996, and the yearly
rate may surpass 2%. This may reflect an increase on the demand
for oil by approximately 1.5 million barrels per day.
Second, the US continues to demand more imported oil because of
the expansionary phase of its business cycle and the constant
dwindling of its internal oil reserves and supplies. Third, because
LJN Resolution 986 has currently been suspended, Iraqi oil will
not enter world oil markets for the time being. Fourth, with the
new leadership in Israel, a further deterioration of political
stability in the Middle East is expected, despite the handshake
described above.
Given the parameters in which Mr. Netanyahu moves and his conviction
of Greater Israel, I do not anticipate a meaningful revival of
the Peace Process. To the extent that the US is perceived as siding
with Israel, Arab leaders, no matter how friendly they are with
the US, will not be able to prevent sentiments against both countries.
Rising hostilities may threaten the US presence in the region
on a much wider scale and explode. If so, the price of oil is
certain to rise.
On the other hand, if a successful coup takes place in Iraq, and
the new leadership normalizes relationships with the US and its
neighbors, the price of oil will drop to even less than that of
1995. Economic sanctions will be removed, and Iraq will be allowed
to sell its oil in world markets again. Otherwise, the price of
oil will fluctuate around the price prevailing before the recent
tension.
The interaction between economic factors and political developments
which affect the price of oil was obvious when it appreciably
increased in 1996, compared to 1995. As oil traders anticipated
the UN's plan for Iraq, world demand for oil steadily increased.
However, the traders postponed some of their purchases and awaited
tile fall of oil prices until the Security Council would allow
Iraq to sell its oil. Meanwhile, the UN debate over the resolution
continues longer than expected, and oil traders have found reserves
dwindled to critical levels. Hence, a sudden demand for oil occurred,
and prices rose. In view of these current economic factors mid
the political turmoil and instability in the Middle East, I do
not expect any substantial decline in the price of oil in the
near future.