My old pal Kaletsky was at it again in the Times earlier this week, telling us that we should rip up our economic textbooks, because the record price level for oil is nothing to do with fundamentals like supply and demand. According to Anatole, it's all caused by speculation. It's the usual mix of bombast, misused statistics and a total inability to understand how financial markets actually work. Look it up for yourself if you want: I'm going to take a different tack.
Sure, $135 a barrel is expensive by historical standards, but we know oil users will stump up a lot more -- because they already are. UK prices for unleaded fuel, near £1.13 per litre at the time of writing, equate on a rough calculation to well over $350 a barrel. Prices in much of Europe are a bit lower (because of the strength of the Euro) and they're lower still in North America (because of stupidity), but the plain fact is that consumers throughout the developed world are signalling to the producers that they are willing to pay up to fill up.
I like to look at this in terms of the slightly arcane theoretical concept of economic rent. Economic rent is the difference between the price people are willing to pay for something, and what it would actually take to induce the producer to produce it. (There's a fuller explanation here).
It seems people are prepared to pay $300 a barrel, but Saudi or Iraq, which are still swing producers, and so can be seen as representing the marginal (i.e. next) barrel of output, have costs not far above a dollar a barrel. That gap is economic rent, and energy prices worldwide are all about determining who gets to keep the rent. In many of the OPEC countries, where fuel is very cheap, it's the consumer who benefits; in North America, where fuel taxes are very low, the rent is divided between the consumer and the Government. In Europe, with its history of high fuel prices, the Government is grabbing a large chunk of the rent for itself. (I'm leaving the oil companies aside for the moment, but we'll come back to them).
As I see it, right now the producers are seizing back some of the economic rent from oil users consumers in the consuming countries, and their governments. It's a bit rich for the latter to complain when taxes still make up such a high proportion of the final price: there's no logical principle that says governments have a right tomore of the revenue from a diminishing resource than the people who actually own it.
I've always assumed that the producers have always known they could charge much more for oil, but have held off because they knew that higher prices for crude would spur research into alternatives. This is indeed happening now, with increased production from expensive alternatives like the Alberta tar sands, renewed exploration in existing non-OPEC producers including the USA and UK, and the global, very possibly counterproductive push into biofuels. All of these require much higher prices than the Saudis do (i.e. the economic rent is much smaller), but the price mechanism is working as it should. However, all of these alternatives will take a long time to bear fruit, so OPEC is making hay while the sun shines.
What about the oil companies? They have always claimed that they don't benefit from high oil prices, yet to the surprise of no-one both BP and Shell in the UK recently announced a staggering increase in profits for the first quarter of this year. The part of this that I always find most amusing is that the companies always insist that selling fuel is unprofitable. Sure, it's not very lucrative for the guy manning the pump: the margin on UK petrol sales is apparently about 2 pence a litre, which is why they're so keen to lure you into buying sandwiches and chocolates when you pay for your fuel. But at the end of the day, all of the profits of the oil companies are derived from selling the stuff: there would be no margin in production, refining, storage transportation or anything else if there was no end buyer. The companies can allocate their costs and revenues between these stages of production in order to minimise taxes or to deflect public anger, but it's all derived from the consumer in the end.
My only conclusion here is that oil is a unique market, one in which statistics need to be viewed with even more scepticism than usual. Supply and demand still rule, but it can sometimes be hard to figure them out.
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