Are high oil prices such a problem? - Outside View by Asad Dossani

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Are high oil prices such a problem?
Jun 13, 2011

According to a recent IMF release on the impact of high oil prices, they estimated that for every US$5 increase in the price of oil, global GDP falls by 0.2%. So if oil went from the current US$ 100 up to US$ 150, global GDP would fall by 2%. The impact is greater on emerging economies; especially in the manufacturing sector where production is energy intensive.

The most recent OPEC meeting ended with a decision not to raise output. It had been forecasted that they would increase production to keep a lid on rising prices, but the move was blocked primarily by Iran and Venezuela. Oil prices rose on the news.

The OPEC meeting highlights an important dilemma faced by oil producing countries. The more they restrict output, the higher prices will be, and the higher their profits will be. At the same time, if prices go too high, most economies will slow down and overall oil demand will fall.

The answer depends on a concept referred to as price elasticity. Price elasticity is a measure of how much demand changes when prices change. In the short run, oil demand is highly inelastic. This means that if prices go up, demand falls only slightly. Estimates suggest that it would take a 20% price increase in oil for our demand to fall by 1%. This explains why many oil-producing nations want to keep prices high. Profits would rise if supply were restricted.

In the long run, demand is not as rigid. If oil prices keep rising, over time people will reduce their consumption as they substitute to other sources of energy. Technology will also improve to be more energy efficient. In fact, the best way to encourage substitution to other energy forms, as well as more efficient uses of energy, is through a higher oil price.

High oil prices will surely hurt in the short term, as economic growth will fall. In the long term, it may actually be beneficial, as it would reduce dependence on oil. The reason we care so much about what happens in OPEC meetings is because we are quite dependent on oil. So rather than continuing to hope that OPEC keeps supplies plentiful, the best long-term solution is surely to reduce dependence on oil and on OPEC in the first place.

How can this be achieved? To start, letís not worry about prices going through the roof. The higher the price goes, the more it becomes in our incentive to consume less oil, and the quicker dependence can be reduced. Other than that, the real key will be technological progress. The more research that goes into developing alternative energy sources and improving efficiency, the easier this process will be.

Disclosure: I do not hold the currency/commodity discussed in this article.

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

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