The price of oil has been rising for some years. And this has become a big problem for the world economy. We analyze the 10 most important reasons why the price of oil rises.
- Currency Devaluation by Governments
- Increasing Global Oil Demand
- Bankruptcy of Fracking Companies in the United States
- Difficulties increasing Oil Production in the West
- Lack of foresight by Western governments
- Wrong Energy Policies
- Supply Chain Issues
- War between Russia and Ukraine
- Russia’s Disconnection from the Western Economy
Since trading at negative prices in March 2020, the price of oil has risen dramatically. From 2020 to 2022 the price increase has been very strong. And while prices have moderated since the peak in early 2022, they remain elevated in 2023.
While the 2022 peak was still below the all time high seen in 2008, when crude oil prices reached $147 per barrel, what matters for the world economy is the rate of change. Oil is an input to pretty everything in our economic system. If its price goes up, so does the production cost of many goods and services.
Therefore, after having run our economy on cheap oil prices for several years, an adjustment upward is likely to have severe consequences on both companies and consumers.
Next, we analyze the top 10 reasons why the price of oil rises. As you will see, understanding how the price of crude oil is determined is highly complex.
There are many variables that affect the demand for oil and even more variables affecting its supply. At the same time, the way in which the market works, through futures contracts with a certain delivery date, adds another layer of complexity.
These 10 reasons must be understood by the effect they have on oil supply or demand. The less supply or the more demand, the higher the prices. The more supply or the less demand, the lower the prices. It all boils down to that.
Consequently, these reasons must be analyzed separately. Obviously, many of them are related to each other. But none of them exerts such influence on the market that it can move prices on its own in the long run.
Reasons Why the Price of Oil Rises
1) Currency Devaluation by Governments
There are many reasons why the price of oil is rising, but one of the main ones is the monetary devaluation that governments have been carrying out since the great financial crisis of 2008.
If governments and central banks were not determined to increase public spending and monetize government debt, prices would be lower across the board. And that applies to housing as well as oil prices.
Since the 2008 crisis and the outright rejection of austerity, governments have massively increased their spending, concentrating power in the public sector and weakening the economy. That overspending, too high to be paid for by taxes, has been financed by monetary expansion. And if there is more money circulating, prices will tend to rise.
The 2020 crisis pushed public deficits and monetary expansion to even more extreme levels. In many countries, including the United States, the Eurozone and Japan, the amount of money in the system increases by about 50% in just 18 months.
This massive currency devaluation caused money to lose value. When that happens, the cost of living increases. And the price of oil goes up. It is not that oil is more expensive than before, it is that the money is worth less.
2) Increasing Global Oil Demand
Although we often think of oil as an energy source “of the past,” the truth is that global oil demand increases almost every year.
Oil consumption in the developed world has been mostly flat for a couple of decades, and it has been gone down a bit in some of these countries. After all, trends such as the adoption of electric cars are noticeable. But that does not mean we can live without oil.
On the other hand, economic growth in developing countries, where most of the world’s population lives, leads to higher energy demand. And oil is the most important energy source.
Therefore, if we look at global oil demand in aggregate, we will see that the world requires increasing amounts of oil to function. And that trend is likely to continue for a couple more decades.
Higher oil demand is a variable that, by itself, exerts upward pressure on energy prices.
3) Bankruptcy of Fracking Companies in the United States
This variable affecting the supply side of the oil market has contributed to much higher prices. It is the large number of bankruptcies of shale oil companies in the United States, also known as fracking.
Fracking is a technology that makes it possible to extract oil from the subsoil quite quickly. But it has a couple of problems. First, it has a negative effect on the environment, making it complicated to obtain the necessary government permits or funding.
Second, fracking is an expensive technique. As a result of that, either the price of oil is high, or it is not worth extracting that oil.
The United States had a boom in the fracking industry in the early 2010s. Thanks to this, the country was able to increase oil production so much that it ended up becoming a net exporter for the first time in many decades. But that did not last.
An increased oil supply in the world market caused prices to fall sharply, especially in 2019 and early 2020. Consequently, most American fracking companies went bankrupt. They stopped pumping oil, reducing the available supply and sending prices higher.
With very high prices, we could see a fracking boom again. This would help prices moderate.
As they say in the commodities world: the cure for low prices is low prices (because they lead to a reduction in supply that causes prices to rise), and the cure for high prices is high prices (because they lead to an increase in supply that causes prices to fall).
4) Difficulties increasing Oil Production in the West
We continue to talk about the supply side. This time to comment on how Western governments are partly responsible for much higher oil prices.
For several years, many Western countries have been implementing policies to weaken the oil industry. The eagerness to implement the green agenda has come hand in hand with horrible decisions for the well-being of the population.
In this sense, obtaining permits to explore new deposits or, once found, to develop them and start producing oil, has become extremely difficult, if not outright impossible. This has been happening in countries such as the United States or Canada, highly dependent on the oil industry.
At the same time, these governments have been pushing for new financial regulations with the aim of promoting green investments and penalizing investments in fossil fuels.
The consequence has been that oil companies have had much less capital to invest, increasing their financing costs, and discouraging oil extraction.
This has led to lower oil supply in the West, pushing prices up. This has had consequences on the geopolitical world, since the West has become more dependent on countries such as OPEC and Russia to meet its energy requirements.
5) Lack of foresight by Western governments
The West’s lack of foresight has been another thing to consider. Many governments had underestimated the importance of oil for our economy and daily lives.
Oil remains the most useful energy source of all. Oil concentrates a lot of energy, can be easily transported given it is liquid, unlike gas, can be used at any time, unlike solar or wind energy, and is easy to consume, unlike nuclear energy.
That is why it is very useful to always have abundant oil reserves. Many countries, including the United States, Germany and China, have what are known as strategic oil reserves. They are government oil reserves equivalent to several months of consumption.
The strategic oil reserve is there with the aim of ensuring that a country and its economy can function normally if the oil supply is interrupted.
Nevertheless, some of the countries with a strategic petroleum reserve have been mismanaging it. For example, the United States has been selling part of its reserves with the goal of bringing down the price of oil.
Hence, most Western countries are in a very vulnerable situation in terms of sourcing the oil they need in a time of heightened geopolitical tensions.
6) Wrong Energy Policies
In addition to what we commented in the previous two sections, it is worth mentioning how many governments have been making things difficult for the energy sector.
The green movement has favored renewable energy sources in a disproportionate way, to the detriment of other, more reliable energy sources, especially nuclear.
Solar and wind energy are good to have when it is sunny or windy. The problem is that it is not sunny or windy 24 hours a day. And storing electricity is an extremely expensive task, not feasible if it has to be done at scale.
Plans such as Germany’s intention to shut down all nuclear power plants have put the electric grid in a very precarious situation. If there is bad weather, a factor we cannot control, or problems with the supply of natural gas, coal and oil must be burnt to produce electricity.
In summary: we promote green energy with the aim of helping the environment, but end up burning coal due to lack of realism and proper planning.
Fortunately, some countries are already rethinking their energy policies. It is worth mentioning Japan, which has already begun to reactivate its nuclear power plants. That should put less pressure on the price of oil.
7) Supply Chain Issues
The events of 2020, and especially the decisions taken by many governments in response, have caused serious problems in the world’s supply chains.
This means production processes have been negatively affected. When it comes to producing and delivering goods, several steps are involved: getting the raw materials, processing them, shipping them to factories, the manufacturing process itself, delivery to warehouses, then to stores, etc.
While some of these issues are starting to go away in 2023, it will take time to fully restore the supply chains.
This problem has also affected the oil industry, whose ability to extract, process and deliver oil has been compromised. And this has led to a decrease in supply and, consequently, an increase in the price of oil.
What does Venezuela have to do with the rise in the price of oil? The answer is a lot, although this is not something recent.
The Venezuela factor is one of the most important on the supply side. Venezuela is the country with the largest oil reserves in the world, according to many studies. And until a few years ago it was also one of the main producers and exporters.
However, Venezuela barely produces any oil today. The political and economic crisis in the country has led us to this situation.
How can it be that the country with the most oil in the world is unable to produce, export, generate revenue and improve its standard of living? Because, contrary to what many people think, oil extraction requires huge amounts of capital, technology and expertise.
The Venezuelan government has brought the country to such terrible situation that there is no longer any capital or technology to extract that oil. The lack of Venezuelan oil in the world market puts upward pressure on the price of oil.
The good news is that this should not last forever. In fact, the US government was in contact with Venezuela in 2022 to see if it would be possible to kickstart the country’s oil industry in the future. If that were to happen, the price of oil could fall significantly.
9) War between Russia and Ukraine
The problem with Russian oil must be analyzed in two parts. On the one hand, we have the short-term effects, which we will discuss in this section. And, on the other, we have the long-term effects, which we will see in the next section.
Russia’s invasion of Ukraine has prompted numerous Western countries to impose economic sanctions on Russia. This has been done with the aim of weakening the Russian economy as much as possible.
And, while Russia continues to trade with Europe and other Western countries, trade is not as it was before the war. That has led to supply problems that have caused prices to skyrocket.
This is because the demand for oil is not very sensitive to price. That means that if prices rise, we will consume less, but not a lot less. And if prices go down, we will consume more, but not much more.
Our entire economic system is highly dependent on energy. Therefore, if there are supply problems, we will be willing to pay higher prices.
Obviously, these short-term disruptions will only last for as long as the war lasts. However, after the war, things will not return to the way they were before. At least that will not happen for many years. And that will have important effects in the medium and long term, as we see below.
10) Russia’s Disconnection from the Western Economy
Regardless of how the war and economic sanctions have affected the supply of Russian oil to the West, there will undoubtedly be long-term consequences. And this will put upward pressure on the price of oil. There are two aspects to highlight.
First, some Russian oil may be unavailable to Western countries, because the two blocs, in this case Russia and the West, do not want to trade with each other.
This will be negative for the West, which will have to pay higher prices to import energy from elsewhere. Obviously, it will also be negative for Russia, which will have to accept lower prices, not being able to negotiate freely with any country in the world. But it will be positive for countries trading with Russia, such as China and India, which will be able to buy Russian oil at lower prices.
Secondly, and as we have already discussed when we talked about Venezuela, oil extraction is a complicated process. Capital and technology are needed. And this is especially true if oil is in geographically difficult places.
Russia has huge amounts of oil in the Arctic. Currently, most of these operations are carried out with Western technology, in many cases through partnerships between Russian and Western oil companies.
If Western energy conglomerates completely withdraw from the country, and Russia is unable to import Western technology, Russian oil production will decline. This would mean a further reduction in supply, pushing prices higher.
In the very long term, Russia could raise capital and import technology from other countries, such as China, or even develop technology on its own. But that is not a simple process.
As we have seen, understanding the oil market is not an easy task. There are so many pieces in this puzzle, each exerting pressure in one direction or another. And things can change quickly. That is why the price of oil is so volatile.
My goal is for you to be able to understand some of the forces that have caused such drastic increase in the price of oil. This should help us plan for the future and design smarter policies.
The price of energy is one of the most important variables for the well-being of society. When energy becomes more expensive, the cost of living increases across the board. This leads to a sharp decline in the standard of living of the population.
And trying to fix the problem by creating more laws and regulations, as many politicians would, only aggravates the situation. Imposing price caps, rationing or subsidies would lead to energy shortages and even higher prices in the long term.
What is needed are real solutions that allow the market to balance out and prices to moderate.
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Investing in Oil – Opportunities and Risks