Lack of Economics in Oil

INTRODUCTION

There can hardly be a living sole in the industrialized world that is not aware of the rise and fall of gasoline prices. Especially, when the gasoline price increase is sudden and significant. The price of gasoline and other petroleum products is so pervasive in our lives and lifestyles that from the adolescent to the retiree, there is no greater price awareness for any commodity, product, or service than for gasoline. Yet in the past 28 years, of all the commodities, products, or services, none have experienced as much fluctuations, up and down, than gasoline. There is no other price for a commodity, product, or service that can affect or has affected everyone in the industrialized world as much as the price of gasoline.

The price of gasoline can cause recessions; it can cause economic prosperity; it can destroy companies and complete industries; or it can provide companies and complete industries with windfall profits. On the individual level, the price of gasoline affects how a person will work, how he/she will get to work, or if there is any work.

This paper will very briefly summarize the fluctuations in the price of gasoline the world has seen since 1973, and some of the major events that affected petroleum producers and consumers during this period. And this paper will attempt to show that these price fluctuations did not always follow the textbook models of supply and demand, and will offer some of the reasons why the causes of the deviation are numerous and complex and how political policies also help cause such deviations. And finally this paper will try to put the prices of oil and gasoline in perspective with other indices.

HISTORICAL BACKGROUND

From the beginning in 1849, when Edwin Drake drilled the first oil well in Titusville, Pennsylvania, the story of oil has been a fascinating saga of epic proportions. Next to religion, it has been fought over in more wars, it has caused governments and their leaders to rise to power or to topple, and it has caused entire societies to thrive and prosper or to perish in squalor. In no other story can we see the whole cornucopia of political and economic principles at work.

When the first oil wells were pumping out the oil, no one at that time could envision the future that was in store for oil, as the only uses initially for oil, were lighting and heating. But with the 20th century and the automobile, with its internal combustion engine, the real demand for gasoline was born. Turbulent decades of wildcatting, local oil wars, and the development of the oil companies, filled the Texas and Oklahoma countryside and the headlines of newspapers across the country. But as known oil reserves (what is known to be available for future drilling) at that time were already too small for anticipated consumption, the search for and acquisition of oil became a truly international quest.

As early as the1930s oil exploration and discovery, worldwide, was showing that the arid Middle East possessed the greatest potential for untapped oil. But these newly found oil supplies were not under the native soil of the oil consuming countries, but under the soil of countries with virtually no oil consumption at all. Thus the world was soon to be divided between oil consuming countries and the oil exporting countries.

In the early decades of the 20th century, with much of the Middle East under the colonial rule of Britain and France, American and European oil companies had a relatively easy time keeping the Muslim fiefdoms under control, while the oil flowed. But with the end of World War II, the end to colonial rule, independence, the emergence of local economies, and the instability caused by Israeli/Arab animosity, gradually, the formula became far more complex.

By 1960, the oil rich Middle East countries began to feel that they were supplying the world with extremely cheap energy, too cheap. And although the reserves were the largest in the world, it would not last forever, and the time had come to exert their powers to get more for the oil they were supplying the world. But they needed an organized, single-purposed approach, if they were going to dictate market decisions, including prices.

Oil Exporters Organize

OPEC (an acronym for Organization of Petroleum Exporting Countries) is a multinational organization established to coordinate the petroleum polices of its member nations, and to provide the member states with technical and economic aid. The organization was established in September 1960 by Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. Other members, in chronological order, who joined later, are Qatar, Indonesia, Libya, and Abu Dhabi, which were transferred later to United Arab Emirates, Algeria, Nigeria, Ecuador, and Gabon. The headquarters of OPEC is in Vienna. Policy is formulated at conferences of delegates from member countries, which meet at least twice a year. And it is from these conferences that OPEC policy came forth.

In 1973, at the close of one such conference, OPEC announced that they had concluded an agreement with the oil companies where prices were raised 11.9% with the installation of a mechanism to make monthly adjustments. But that agreement with the oil companies collapsed later that year and the OPEC members announced a unilateral hike of prices of oil by 70%. The price of a barrel of oil jumped from US$3.01 to $5.11, and the world was changed. Two months later the price was increased another 130% to US$11.65 per barrel.

Since those tumultuous months in late 1973, there have been tremendous price fluctuations (see graph, next page), more than any other commodity traded in world markets (including the wild days of precious metals, gold, silver, and platinum, during the early 1980s.)

Commodities Exchanges

The oil exporting countries can declare a price to take the product from their soil, but there have to be buyers in the marketplace who are willing to pay those prices. The world's current oil production and future oil production are bought, sold, traded, and contracted in a marketplace called a commodities exchange. The two major commodity exchanges are the New York Mercantile Exchange in the United States and the International Petroleum Exchange in Europe.

The commodities exchanges had their beginnings back in mid-1800s trading in farm products, forming new exchanges for newly traded commodities. By the late 1800s the exchanges began to merge and consolidate with other exchanges and in 1882 the New York Mercantile Exchange (NYME) was founded. And when the NYME merged in 1992 with rival Commodity Exchange, the union became the world's largest exchange. The NYME trades in more petroleum commodities than just crude