INSIGHTS: Petroleum Studies 101

Getting to $4 for a gallon of gasoline, as we did this summer, took some doing. Only last July we paid $3, and back in July 2004 we paid $2. Many factors combine to drive oil prices.

Since 2004 developing countries have grown 6 percent per year, with China growing at 10 to 11 percent per year. Strong economic growth, coupled with domestic oil price controls in many developing countries, including China and the Middle East, boosted world oil demand by some four million barrels per day.

OPEC (Organization of Petroleum Exporting Countries), though mostly Saudi Arabia, uses surplus oil capacity to balance the market. That surplus capacity began to decline in 2003. By 2005 it was down to one million barrels a day. With little surplus capacity, any disturbances in the market can cause prices to rise.

Most OPEC members have not been increasing their oil production because rising oil prices have poured billions of dollars into their economies and reduced their need to produce more oil.

Arnie Baker is Sandia's Chief Economist of Sandia National Laboratories, Albuquerque, New Mexico.

Other oil producers are reducing production for a variety of reasons. Russia and Venezuela have asserted control over their oil production. Mexican oil production (PEMEX is government owned and prohibits foreign ownership) is down 22 percent since January 2004. Instability in Iraq has kept its oil production low.

Since oil is priced in U.S. dollars, a weaker dollar inflates the oil price and encourages oil exporters to seek higher-dollar oil prices. Since July 2004 the dollar has fallen 22 percent against the Euro, 14 percent against the Japanese yen, and 10 percent against the Chinese renminbi.

A weak dollar means that non-U.S. oil consumers pay less for oil because their currency has more purchasing power.

As the dollar falls, investors tend to move money out of stocks, seeking higher returns in commodities such as oil, metals, livestock, corn, and soybeans. This reinforces a boom in oil and other commodities. If markets believe this will continue over the long term, this pulls up short-term prices as well.

Changes are underway, but many will take time to soften prices.

Saudi Arabia has agreed to increase its oil production.

Oil demand in the U.S. and some other developed countries is beginning to fall. U.S. consumers are purchasing more fuel-efficient vehicles. Most automobile manufacturers have some type of plug-in electric/hybrid or electric vehicle scheduled for the marketplace in 2010 or 2011.

Liquid fuel alternatives from coal, oil shale, and cellulose are being explored, and high oil prices will stimulate additional oil production as well.

The U.S. may find itself having to raise interest rates before the end of the year to help curb inflation, which might slow the economy but also strengthen the dollar.

Many developing countries are trying to cope with both sharply rising food and energy prices, which seem to be fueling broader-based inflation.

Developing countries like China have begun to raise their subsidized domestic oil prices, which could slow down oil demand growth. China's economic growth and growth in oil demand also may slow now that the Olympics have ended. If oil markets see an economic slowdown, believe that changes in consumer behavior will bring down demand, and/or believe supplies of oil and other liquids will ratchet up, oil and gasoline prices could turn down quite rapidly.