High Oil Prices: Implications and Prospects

Pub. Date
25 July, 2008

In discussing oil prices, in sufficient attention focuses on the implications of oil\'s status as an exhaustible resource. The basic economics of such resources is that their prices should be expected to increase at the rate of return on capital. The logic of this is that owners of oil-fields always have the choice of selling them and investing the proceeds in other forms of capital. If they do that, they earn the return on capital. It follows that they must expect a similar return from owning an oil-field. Since the oil does not contribute to production unless it is extracted, it follows that the return can be delivered only by an increase in price.

In recent years owners of oil in the ground have realised substantial returns, but since the 1970s the real return has been 6-7% p.a. and working over a longer period from the early 1950s it falls to about 4% p.a. In broad terms these returns are coherent with what stock market investing delivers. Thus, while the principle does not work on a year to year basis., in broad terms, the level of oil prices today, when looked at from the perspective of the mid-twentieth century, can hardly be seen as a great surprise.

The fact that oil is exhaustible raises the obvious question whether the world will eventually be able to manage without it. The conclusion depends on the response of oil demand to rising prices and here the implications are encouraging. Figure 1 shows the share of expenditure on energy in the United States, and also the real price of energy. It is clear from the graph that, while the share of energy rises in the short term as prices go up, it falls in the long term. A rise in the price leads, in the long term, to a fall in the volume so large that the volume effect more than offsets the price effect and the share of expenditure actually declines. As energy rises in price capital and labour are used to replace energy in the production process and consumers also change their behaviour to save energy. The mechanisms that make this possible include factors such as insulation and improved building design Economic Agenda to save fuel and production of energy from renewable sources. A basic economic theorem on exhaustible resources indicates that, if the expenditure share does decline as the price rises and this process continues, then the world will be able to come to terms with using diminishing quantities of oil without total production falling. The fact that oil supplies are finite does not constrain total output.

This does not mean that rising prices and the exhaustible nature of oil have no implications. The need to replace energy by means of labour and capital means that, although output may not be constrained, output growth is depressed relative to what would happen if oil supplies were unlimited. Moreover consumers need to put money aside to build up the capital stock so that the economy has the capital needed to replace oil as the oil price rises. This means first of all that labour productivity growth has to be lower than it would be if oil were not exhaustible. This phenomenon was seen in the 1970s and early 1980s, when productivity growth slowed below the rates which had been experiences in the 1960s.

Secondly, it means that saving needs to be higher in a world of exhaustible resources than it would be if all resources were renewable. A further economic theorem indicates that, if consumption is to evolve smoothly despite the exhaustible nature of oil, then the proportion of income saved needs to be equal to the value of exhaustible resources consumed. This is, of course, over and above the saving needed to address the problems of an ageing population and the fact that expanding economies inevitably need to save more than stagnant economies because the capital stock needs to be built up. Most of the saving probably needs to be done by the consuming rather than the producing countries.

The United States spent 8% of its income on energy when the oil price in 2007 when the oil price averaged $70 per barrel. This figure includes shipping and production costs but it is plain that, even if the price of oil does fall back to $70 per barrel, net saving needs to be much higher than its current level of under 2% of income. Otherwise the United States will not be in a position to manage the effects of rising oil prices and eventually declining production. The United Kingdom saves a higher proportion of its income than does the United States but it too is almost certainly saving not nearly enough to meet the pressures which are likely to arise from demographic change and rising oil prices.

This analysis suggests that, while governments need to address the savings shortfall, they can otherwise leave market forces to address the problems of oil depletion. Obviously, once one takes account of the effects of global warming, this is no longer the case. As is generally the situation, when market activity results in damage of some sort for which those undertaking the damaging activity do not have to pay, it is incumbent on the government to introduce a system of taxation so as to correct this. High oil prices may limit demand and thus reduce the damage done. But they do not change this basic principle. It follows that governments should not shy away from developing mechanisms for charging for carbon emissions simply because oil prices are high.