What Causes Oil Prices to Fluctuate?

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In a recent article by Jad Mouawad “Crude Oil continues Declines” 2008, Mouawad notes that the price of oil has dropped $10 a barrel and in New York, oil futures fell as much as 5 percent below $91 a barrel in morning trading, their lowest level since February. The price of oil has declined by over 37 percent since it peaked in early July at $145.29 a barrel mainly because of two reasons: slowdown of the economy and falling consumption in Western economies. In particular, Mouawad notes that the decline in oil price was sharp after Lehman Brothers filed for bankruptcy protection, signaling further slowdown in the economy. Moreover, OPEC has lowered its forecast for oil demand this year because of slowing economic growth. However, as oil prices fell, gasoline prices increased because of refinery disruptions caused by Hurricane Ike.

Earlier, Paul Krugman in the New York Times pointed to the fact that oil prices have often been unpredictable. When oil prices were $50 a barrel in 2004, it was predicted to collapse but ten months later, oil price increased to $70 a barrel”. Oil prices have undergone a continuous price surge for five years taking it from $25 a barrel to above $125 (Krugman 1). Many people have attributed the price increase to speculators but then, if that were true, Krugman says there would not have been consistent rise in prices. If prices rose suddenly because of speculation alone, Krugman says it would be accompanied by a decrease in consumption and increase in production, resulting in excess supply which would drive down prices. He further explains that speculation can affect oil prices consistently only if there is physical hoarding of oil. With inventories remaining more or less at normal levels, Krugman proves that rise in oil prices is not due to speculation but due to basic factors such as increasing difficulty in finding oil and the rapid growth of emerging economies like China. The rise in oil prices, Krugman says, was essential to keep demand growth from exceeding supply growth. Even if there is a decline in price, he says it could only be due to a pullback in demand (Krugman 1).

Diana B. Henriques in a recent article in the New York Times (2008) reveals that federal regulators are checking several trading records from Nymex traders as part of their investigation into the sharp oil price rise. The investigation is aimed to find out if anyone is trying to illegally manipulate the settlement price for the Nymex crude oil futures contract for October delivery which jumped as much as $25 a barrel — its highest one-day surge ever — before settling up 16 percent higher at $120.92. The sudden increase has caused analysts and traders to suspect that one or more traders holding short positions (bets that oil prices would fall) were scrambling to cover their bets in a rising market. The oil price had jumped in a day to $130 a barrel – an increase of about $40 a barrel from last week’s low. Javier Blas and Chris Flood, in the Financial Times say that the sudden jump in oil price was mainly due to the weakening US dollar, weaker supplies from Mexico, Nigeria and Saudi Arabia in recent weeks and surging imports by China.

Paul Craig Roberts cites the weakness in the U.S. dollar’s exchange value and the liquidity pumped by the Federal Reserve for the rise in oil prices. He also says that the possibility of an Israeli-U.S. attack on Iran has increased current demand of oil in order to build stocks. Saudi Oil Minister Ali al-Naimi recently stated that there is no justification for the current rise in prices – implying that there are no shortages or supply disruptions, but could be due to speculative or psychological reasons. The recent period of oil price increase coincides with a period of heightened U.S. and Israeli military aggression in the Middle East. When Bush invaded Iraq in 2003, the average price of oil that year was about $27 per barrel and has risen from $27 to approximately $135. A political explanation may be given for the rise in oil prices, the decline and the sudden jump. Possibly, the rise in the oil price was held down as it was expected that Israel would be restrained by the Democrats and conflict ended. But Barack Obama has pledged allegiance to AIPAC and adopted Bush’s position toward Iran and this could be one reason behind the high oil price

Between 2003 and 2006, oil prices rose from under $30 per barrel to reach more than $77 per barrel. During this period, the performance of the U.S. economy remained strong, with real GDP growth averaging more than 3% per year. The U.S. economy did not go into a recession because the additional amounts spent for oil were a smaller percent of GDP than during previous periods of rising oil prices. James Hamilton argues that the relationship between oil prices and economic growth was very complicated. Hamilton’s statistical analyses suggested that oil price increases tend to slow economic growth whereas oil price decreases do little to boost it. Hamilton also found that oil price increases after long periods of stable prices have a bigger impact on the economy than increases that are part of short term swings. Based on the dollar value of U.S. crude oil consumed as a fraction of GDP, the number of vehicle miles traveled, the consumption of gasoline, and the sales of SUV – James Hamilton concludes that consumers are now reacting to the price of oil and that could lead to a recession (Verdon 1). In the context of customer reaction to oil prices, Ford Motor Co. has announced that sales of its gas-guzzling pickup trucks and Explorer sport utility vehicles have plunged. Ford Chief Executive Alan Mulally said the industry had “reached a tipping point” where people have begun to buy vehicles that would cut energy costs (Gossein 1). Meantime, to cope with higher energy prices, American Airlines and United Airlines both raised ticket prices, and American announced plans to impose a new baggage-handling fee. Companies totally unrelated to the oil sector such as SanDisk Corp., the world’s largest maker of the flash memory cards that go in such products as digital cameras and media players, said that sales declined because of rising oil prices. Small businesses have also been hit (Gossein 1).

As a result of rise in oil prices, alternative vehicles have found a new demand. Energy Department figures show that oil and fuel consumption dropped by 2.3% over the last year. And the Transportation Department released data Friday showing that the number of highway miles traveled by Americans in March fell 4.3% from a year earlier. Daniel Yergin says the oil crisis is now much more serious because it comes along with a credit crunch, a housing slump and a slowdown (Gossein 1).

Analysts said that the latest oil price increases have been particularly damaging as they prevented the arrival of $120 billion worth of tax rebate checks that Washington was hoping to revive the economy with. Even if the price of oil stabilizes the price of gasoline is likely to keep on increasing. This is because of increasing demand for gasoline during the summer. Chris Lafakis an economist predicts that if Americans drive as much as they did last summer, and oil prices remain stable, gas prices could hit $4.75 a gal. As a result of oil prices, between February 2002 and September 2005, average gasoline prices increased from $1.15 to roughly $3 per gallon (Gossein 1). Most drivers are forced to simply absorb the additional cots when oil prices rise. Some can shift daily patterns to drive less. A severe disruption in oil supplies would bring catastrophic consequences for many families. one study found that with oil at $120 per barrel, household energy bill including oil and heating gas, would roughly double”(Roberts, 2008). On the international level, with oil being traded in U.S. dollars, the dollar is pegged against oil. High oil prices not only affect the American industries, they also devalue the dollar. The price of oil is now seen internationally to be a true reflection of the state of economy of U.S. (Officer and Hayes 3)

I feel that speculation is the major cause behind the fluctuations in the price of oil. It makes a lot of sense as the oil price is not only increasing in sudden jumps there are also intermittent phases of oil price decline. This can occur mainly during when there is speculation and trading in oil futures. Due to the large margin in the futures market, it is possible to trade ten times more oil than one can otherwise afford. Moreover, the futures market has become the public driving force in pricing oil. Though much of the world’s oil is purchases through private deals, market price cannot be set by private deals. Transparent pricing in the futures market facilitates in establishing the accepted benchmark for the price of oil. I firmly believe that the futures market dictates the price of the oil.

Works Cited

Gossein, G. Peter (2008). Relentless rise in oil prices tests economy’s resilience. Los Angeles Times. Web.

Henriques, B. Diana (2008). Investigation Widens Into Unusual Oil Price Rise. The New York Times. Web.

Krugman, Paul (2008). The Oil Nonbubble. The New York Times. Web.

Officer, J. Ari and Hayes, J. Garrett (2008). Are Oil Prices Rigged? Time. Web.

Roberts, Craig Paul (2008).Why the Oil Price is High. Chronicles. Web.

Verdon, Steve. James Hamilton on the 2008 Oil Shock. Outside the Beltway. Web.

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What Causes Oil Prices to Fluctuate?

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