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implying that oil prices were driven by growing world income and demand.
Insensitivity to Price Change
Consumers of oil and oil products arenot very sensitive to price changes,especially in the short run. In eco-nomic jargon, the price elasticity of demand is very low. This is mainly because oil’s use for transportationpurposes accounts for two-thirds of consumption, especially in developedcountries, where there are no closesubstitutes in the short term. Whenconsumers are insensitive to pricechanges, a shock in the oil market, whether from increased demand orreduced supply, will heighten price volatility.To see whether rising oil pricesfrom 2007 through mid-2008 arecompatible with the elasticities for oilestimated in the energy economicsliterature, we performed a simple cal-culation. Taking the developed-worldand emerging market GDP growthrates from the International Monetary Fund, and making some assumptionsabout income elasticities of demand, we can calculate the higher oil demandimplied by these growth rates. Then,by comparing actual growth in con-sumption and the calculated consump-tion numbers, we can determine theoil price elasticities they imply. Wefound that these elasticities wouldhave to range from 0.01 to 0.08 forprices to surge as they did in 2007 and2008—well within the estimated elas-ticity ranges in the energy economicsliterature.
OPEC Market Power Firmed Prices
The oil market is not perfectly competitive. The Organization of the Petroleum Exporting Countries(OPEC), since its formation in 1970,has been an oligopolistic producer,trying to boost prices by controllingmembers’ output (with more successat times of higher demand growth).The remaining non-OPEC producersform a price-taking, competitive fringe.OPEC’s market share has dwindledfrom 52 percent in the early 1970s toa still hefty 42 percent today. In the1990s, as the market grew, so didboth OPEC and non-OPEC produc-tion. However, non-OPEC oil outputgrowth flattened around 2003, whileOPEC output continued expandingfrom 37 percent in 2003 to the current42 percent level. Increased marketpower, coupled with rising demand, was a significant factor keeping oilprices high.
World GDP Mirrors Oil Price Growth
–40–30–20–100102030405060World GDP growthReal oil price growth
SOURCES: International Monetary Fund; Bureau of Labor Statistics;
Wall Street Journal
Reduced OPEC Excess Capacity Helped Tighten Market
Dollars per barrel Million barrels per day
WTIOPEC excess capacity012345678201020082006200420022000
NOTE: Oil prices are monthly averages.SOURCES: U.S. Energy Information Administration;
Wall Street Journal