Spot oil prices climbed to new highs last week even as the price of the December 2011 futures contract fell, steepening the backwardation I commented on here and here. A look back at what happened in the early 1980’s may give some insights into what the market may be expecting next.
Last week’s news was not encouraging. British Petroleum announced that U.K. oil production was down 10% over the last year, suggesting that the decline in production that began in 1999 as North Sea fields are depleted may be accelerating. Concerns about possible turmoil in Nigeria may have also worried markets. But the most important factor continues to be strong world oil demand. 
Why didn’t the longer term futures prices, like that of the December 2011 contract, move up with spot prices in response to the news? Some insight into this may come from looking back at what happened to oil markets in the late 1970’s and early 1980’s. The graph at the right displays the price of oil over the last half century quoted in current dollars, calculated by dividing the price of West Texas Intermediate crude by the U.S. consumer price index. The 1970’s were a turbulent decade in which the OAPEC embargo, Iranian revolution, and Iran-Iraq war resulted in supply shocks that more than quadrupled the real price of oil, driving it to a peak in 1980 that would correspond to $95 dollars a barrel today.
World oil production fell over 10 million barrels a day between 1979 and 1982. But the interesting thing to note is what happened to oil demand after these events, as oil use stayed below 55 million barrels a day until 1985.
In part the drop in world petroleum demand was caused by the twin recessions of 1980 and 1982, which I’m still hoping won’t be repeated this time. But even after the economic recovery from these recessions was well under way, oil use remained low well into the decade.
This episode illustrates one of the key features of the petroleum market, which helps us understand both the current turbulence of the market and one source of potential longer run stability. The short run demand curve is quite inelastic– huge price increases are necessary if you want to cut oil use significantly over the next few months. When, as in the current environment, there is limited excess capacity, supply is quite inelastic as well. The result is that spot oil prices are going to be extremely volatile in response to any disturbances on either the supply or demand side.
Given more time, however, as new vehicles and equipment get replaced, there are lots of things that businesses and consumers can do to reduce oil use. Most of the demand response to today’s high oil prices will not be seen until several years down the road. Whether the price increases so far will be sufficient to restore a longer run stability to oil markets without a global recession is the big question we’re all pondering at the moment.
Econbrowser is produced by James D. Hamilton, who is professor of Economics at the University of California, San Diego
