As crude oil prices approach their highest levels in the last two years, fears are growing that economic growth could be negatively affected as a result. If prices do continue to climb and eventually pass the US$ 100 per barrel mark, these fears will only intensify. It is possible that this could happen sometime next year, if demand remains strong.
Oil demand from emerging economies has been growing as the economies have been growing. Demand from developed economies has also started to grow, as their economies start recovering. The rise in oil prices is in large part driven by the fact that economies are growing and GDP is rising. Do these rising oil prices pose a threat to the global economy?
Given that most production requires the use of oil, a high oil price does increase costs for businesses, and ultimately consumers. It can cause economic stagnation. There are only two ways in which this problem can be solved. First, we can increase the supply of oil so thatís its price falls, and we have more oil available to create goods and services. This will reduce costs, increase growth, and be good for everyone.
Unfortunately, oil is a finite resource, and increasing the supply is not a viable long-term solution. In the short-run it can be done to temporarily reduce prices. In the long-term, supply is constrained. The other way in which we can solve this problem is to use less oil in the first place, while still maintaining economic growth.
This solution requires improvements in technology that allow us to use less oil. We would need to make things more fuel efficient, as well as be able to rely on alternative and more sustainable energy sources. This type of solution is a long-term ongoing process. Technological improvements will happen over time.
What can be done to encourage this behavior? Its simple: A high crude oil price. If we have high oil prices, companies, governments, and other organizations will have a strong incentive to use less oil. This will encourage them to devote efforts to researching alternative energies.
In the short-term, we are very dependent on oil. There is no doubt that we will suffer economically if crude oil prices continue to rise. However, in the long-term, we can be much less dependent, provided we invest in technological improvements to use less oil. And the best way to encourage this investment is by allowing the crude oil price to rise.
We have already seen this occur in some instances. For example, cars are much more fuel-efficient than they used to be. Hybrid and electric cars are good examples of technological improvements that have resulted because fuel prices have been high. Most electronic devices are also more efficient than they once were. New computers use much less energy than computers five or ten years ago. These kinds of improvements only occur due to rising energy costs.
In January 1999, crude oil prices were around $10 per barrel. Despite the price increasing by 9 times that amount over the last 12 years, we are in a much better economic position than we were at that time. I am optimistic that the same thing can occur going forward.
Disclosure: I do not hold the currency/commodity viewed/opined in this column
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!