The Reasons Behind the Rising Real Oil Prices

Business Economics Use supply and demand economic theory to explain why the real price of oil is currently so high.
All diagrams are the courtesy of

The issue at hand is the reason behind the growing real price of oil. Oil prices have recently crossed the $90 a barrel threshold and although one of the reasons is the dollar’s falling exchange rate there are other reasons like inflation and demand and supply factors. The diagram below shows the predicted oil increase in the coming months.
Crude Oil Price Forecast
West Texas Intermediate Spot Price. USD/bbl. Average of Month.

Forecast Value

50% Correct
80% Correct
Updated Wednesday, November 14, 2007

The real price of oil would require the discussion of the involvement of supply and demand in the oil price hike. This has to be done without discussing inflation or the exchange rate mainly because the real price as compared to the money price of something ignores the effects of both of the above.
The oil market has highly inelastic demand and supply especially in the short run mainly because there are a few if any substitutes for it. Scientists have attempted tirelessly to create solar and CNG run cars and there has been an attempt to harness nuclear power at all levels of the industrial use.
Crude Oil Prices: The diagram shows the likely effect of the decreasing demand and supply factors on the real oil prices

The following shows the short-term demand curve for oil which where a large change in price is likely to have little effect on demand

Oil supply is also inelastic because of the cost of the refining and infrastructure costs incurred by the crude oil suppliers to make the oil marketable. Also associated are the costs of maintaining such infrastructure because the cost of infrastructure remains constant regardless of any output.

Therefore small changes to the supply or demand curve will cause large changes to the real price of oil.

For example when in 1973 the OPEC cartel announced a US-Israel Boycott there was a reduced supply in the overall oil output therefore for any given price level, there would be lesser oil supplied. Natural causes like earth quakes or war situations also have a significant effect on oil supply. An example is the recent disaster of the Hurricane Katrina which affected production in the Gulf of Mexico. More so the increasing industrial demand for oil in the third world countries is also a factor in the rising oil prices. In the following diagram at any given level of price, more oil is demanded and the price increases.

However with regard to oil prices in the long term there are other factors at play. The long term demand and supply of oil are very much elastic. Long term demand is likely to change if the oil shortage is constant. A short term disaster may change consumer behaviour temporarily but in the long term if the supply remains short constantly the following might happen.
People might start adopting to the shortage by using more fuel efficient cars, using CNG,solar power or even nuclear power.
At the industrial level nuclear power or coal power can replace oil powered generators.These are slow changes but have permanent long term effects on the demand of oil.

There might be increased oil exploration in areas where previously it was too difficult to start wells. This may be because a supplier is restricting the oil supply. The effect of finding new oil fields will be to break already established cartels or oligopolies.

There is not just one answer to the reasons behind the rising real oil prices.This has become an issue much influenced by war and politics.The demand and supply factors are very much influential in the short term but in the long term the consumption trends and investment are greater reasons for the shifts in the demand and supply curves.



2. Economics Explained ,Maunder Peter Collins, Revised Third Edition 1995