Date
12 January 2020
Oil supply is becoming more abundant while demand is expected to be capped as most emerging markets, especially China, are slowing down. Photo: Reuters
Oil supply is becoming more abundant while demand is expected to be capped as most emerging markets, especially China, are slowing down. Photo: Reuters

Why higher oil prices won’t last

Oil prices shot up last Friday after the United States launched an airstrike that killed an Iranian military commander in Baghdad.

Investors worried that a new war in the Middle East was brewing. When the Gulf War broke out about two decades ago, the price of crude (New York WTI crude one-month futures) jumped from just US$15 to over US$40.?But towards the end of the war, the oil price slipped to below US$20 and stayed at that level for years.

Historically, the impact of war on oil prices has been sharp but short, and not all wars drove up oil prices. During the occasional wars in the region in the late 1970s and up to the most recent, oil prices responded only in very few instances.

The international market price is generally governed by two major factors, macro and micro. The macro factor is inflation. But since the start of the Great Moderation (1984), inflation has been contained and its correlation with oil price growth somehow has been delinked.

The micro factor refers to demand and supply. Simple economics tells us that price rises with demand but falls with supply. Thus, demand less supply, or simply “excess demand”, should be proportional to the price. This is empirically true.

In the accompanying chart, we see excess demand for crude (in million barrels per day) moving in tandem with the oil price. In fact, the former is a predictor for the latter with a time gap of about two quarters?(compare the blue and red horizontal time axes).?As the excess demand for crude went up over the previous quarters, the price of oil is expected to go up at least in this quarter.

However, the current boom seems more cyclical than structural. Oil market is known to have inelastic supply, implying a relatively more vertical supply curve than the demand curve. Thus, oil prices are more sensitive to the same quantity of demand shock than the supply shock.

Oil supply is becoming more abundant amid the shale boom with members of the Organization of the Petroleum Exporting Countries (OPEC) failing to cooperate for an effective supply cut.

Meanwhile, demand is expected to be capped as most emerging markets, especially China, are slowing down. And with electric cars becoming increasingly popular, oil demand could take an even harder hit.

Therefore, speculation in the oil market?should only be a short-run phenomenon while the risk of stagflation is much lower than that of stagnation.

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RT/CG

Chart: Reuters


The author is Adjunct Professor in the Department of Economics and Finance, City University of Hong Kong and previously the chief economist of a bank. (facebook.com/kachung.law.988, [email protected])
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