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Supply, demand and oil

  In analyzing the world market for crude oil, one can expect a trend toward higher prices -- even higher than the current $55 a barrel. There may be some ups and downs, but the overall trend is on the rise. The reason is that oil production has reached the maximum possible level, yet world oil consumption is now greater than what can be supplied.
    In an August 15 Op-Ed in The Washington Post, Prince Bandar bin Sultan, the Saudi ambassador to the United States, argued that high oil prices are not in the best interests of Saudi Arabia or the world's economy. Hence Saudi Arabia has always attempted to stabilize the price of crude oil through its production policy. After the second oil shock in 1979, Saudi Arabia increased its production of oil, resulting in a downward crude-oil price trend in world markets.
    It is not in the economic interests of Saudi Arabia or the world economy to manipulate oil production in an attempt to provide stability in oil markets. As oil is a depleted natural resource, its value when extracted in the future is higher than at present. Saudi Arabia ought to pursue a production policy compatible with its own economic interests. Its development is based on the conversion of its subsoil resources into other assets such as plants, equipment, education and technology. Obviously the conversion process can be carried on at different rates. An optimum rate is that at which oil should be pumped so that the present discounted value of the income created in the conversion process is maximized.
    Saudi Arabia has sold and is selling far more oil than it would if these basic economic principles were observed. The excess -- the difference between the volume of oil actually supplied and the volume that should be supplied in the strict observance of the national economic interests of Saudi Arabia -- is in fact a subsidy it grants the West, Japan and other oil-importing nations.
    Yet, Saudi Arabia cannot flood world markets when world demand exceeds the maximum that can be produced. World demand for crude oil is increasing because of the almost double-digit growth rate of China (which is now an oil importer), the high rate of growth in India and other known factors. Meanwhile, oil traders fear sabotage of oil pipelines and the grave instability created by the war in Iraq. All such factors will keep putting an upward trend on the price of oil until demand starts to decrease.
    Turning to the world economy, there is no system better than the market economy, where Adam Smith's invisible hand allocates resources efficiently. Attempts to manipulate supply and demand cannot be sustained in the long run. At the 2003 rate of world consumption of oil -- 78 million barrels a day -- the world will run out of oil in 40 years without new discoveries or technological breakthroughs. This means that more than half of the U.S. population would witness the depletion of such a valuable natural resource in their lifetimes. But a policy of non-interference with supply and demand would permit the the market economy to lead towards a way out. As the price of oil increased, demand could eventually decrease. If the price of oil continued to rise, consumers would have to find ways to reduce demand, such as driving small cars and better insulating their homes. This may increase the lifespan of oil reserves.

    At the same time, supply could increase from marginal wells and from new successful exploration. The dual effect of an eventual decrease in the demand for oil and a possible increase in supply would reduce the price of oil in world markets But let us assume that there are no more oil reserves to be found. In this case, the price of oil will keep increasing, making it profitable to invest in technologicalimprovementsor alternate renewable sources of energy. The way out is technology. Research needs to be financed through the miracle of Adam Smith's invisible hand, not through government expenditures.

    Granted, high oil prices would have a negative impact on world economic growth while Third World oil-importingcountries would face further hardships and worsening of economic conditions. The world economy can live through hardships caused by negative growth as it has done in the past. A recession could possibly result from excessive oil prices in the course of adjustments in finding cost-effective renewable alternative sources of energy. But paying this price might enable the world to avoid the even worse scenario that would result if the world industrial machinery suddenly stopped when oil supplies were depleted. This could occur by mid-century.

    

    Ibrahim M. Oweiss, an oil economist, introduced the Oweiss Demand Curve in an attempt to explain the fluctuations in the price of oil.

Editorial Notes: Saudi Arabia, of course, releases more oil than it would for purely economic reasons largely because of an understanding that in return the United States will provide military support for the ruling regime if required. While I can't agree that a pure market system would provide timely enough price signals - it would at least be better than one which warps price signals. The author, unfortunately, expresses ignorance of the Hubbert curve. -AF

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