Wednesday, April 25, 2012

Oil Prices Seem Sticky Above $100 A Barrel Despite Lessening of Iran Tension

A critical reason for the lack of growth in the economies of Europe, Japan, and the U.S. is the high cost of oil. Expensive oil serves as a tax on economic activity. Two of the primary factors getting the blame for the high cost of oil are: 1) speculators; and 2) the threat to supplies due to a potential conflict between Iran and either Israel or the U.S.

The price of a barrel of oil trading on the NY Mercantile Exchange is basically flat today at midday despite news that "Iran Considers Halting Nuclear Expansion to Avert EU Oil Ban". While it may be that traders are discounting this news as simply more posturing by Iran, it is disconcerting that it has not been a bigger market mover.

The price of oil may be permanently stuck at a price above $100 a barrel. Demand keeps increasing while supply stays flat and the cost of production goes up. Yes, lots of new sources of oil are being found or are becoming economic to produce now that oil is so pricey. However, these new sources of supply are barely keeping up with the growing demand from Asia and South America. Further, as the supply from established oil fields with low cost of production diminishes by about 5% per year, the high cost of production from new sources virtually guarantees that oil will never again drop below $80 per barrel for an extended period of time, unless there is an absolute collapse in demand. The supposed  "speculative bubble" may not exist, but simply be a function of traders foreseeing that future demand is likely to outstrip future production.

Some economists judge that the growth of economic activity in Europe, Japan, and the U.S. since WWII was largely based on the availability of cheap oil. If they are correct, it raises serious questions about how these developed economies can rekindle growth given the massive debts they have incurred and the high costs of supporting ageing populations. In addition to the high cost of oil, all three economies have self imposed incremental energy costs. Japan and Germany are paying more for electricity due to shutting down nuclear plants. In the U.S., cost efficient coal power plants are being shut down.

What will it take for Japan, Europe, and the U.S. to re-ignite economic growth despite high oil prices? Lessening of tensions with Iran may not lead to a plunge in the price of oil. Thus, given the drag on the economy from high oil prices, the agonizingly slow pace of economic growth in the U.S. of the last couple of years may be as good as it gets.


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