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Thesis & Antithesis

A critical perspective on energy, international politics & current affairs

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Location: Washington, D.C.

greekdefaultwatch@gmail.com Natural gas consultant by day, blogger on the Greek economy by night. Trained as an economist and political scientist. I believe in common sense and in data, and my aim is to offer insight written in language that is clear and convincing.

04 August 2006

Oil costs what we pay for it

(This is a post I made to an online discussion poll conducted by the Financial Times (link). The question was: Can the world live with oil at $80 per barrel?)

It is almost pointless to ask “Can the world live with oil at $80 per barrel?” For the past few years, the world has lived with very high oil prices and has actually fared quite well, at least at the macro-level. True, economic growth may be starting to slow in some places, but this is often attributable to factors unrelated to oil. Today’s oil crisis is hardly a replica of the 1970s when economists had to coin a new term—stagflation—to describe the peculiarity of the predicament that had befallen upon us.

The reason that the world has coped with high prices is that the price hike is demand driven. Just like any other product, the price of oil is driven both by fundamentals (what it costs to produce it and how scarce it is) and by the market’s willingness to pay for it. Usually prices settle in between these extremes, even in a market where politics tamper with prices all the time. This means that prices are at $75/bbl because firms and individuals think that buying oil at that price is better than not buying oil at all. Ultimately all prices reflect their marginal product and so oil prices will keep rising until the cost of a barrel exceeds its utility for firms and individuals.

The risk that we face today is twofold: first, fuel inflexibility may be forcing buyers to pay for oil a higher price than they can afford. But, thankfully, this is only a short-run issue, and given the economy’s resilience in dealing with higher prices, a longer-term adjustment may not be too painful. The second risk is an asymmetrical ability to pay for oil: given that oil prices are set at the margin, a problem exists if the marginal buyer can set prices that are too high for other consumers. Many fear that China is playing that role today given its ability to grow despite higher oil prices. But this risk, however, is less acute when an overall slowdown in demand will help bring prices down.

In other words, it’s not whether the world can live with an $80 barrel oil; rather, the price of oil will mostly reflect what the world can live with.

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