RUNNING ON EMPTY?

Don't blame the oil companies

By Henry Lee Published: July 24, 2008

If you listen to many elected officials and political pundits, you might think oil companies or speculators are to blame for high oil prices. The evidence does not support such a verdict.

It is true that some major oil companies have made huge profits, but this does not mean that they are responsible for the price of oil. When a consumer buys a gallon of oil, the company benefiting is more likely to be the national oil company of Saudi Arabia, Nigeria or Venezuela rather than Chevron, Shell or Exxon. About 86 percent of the world's oil is produced by state-owned oil companies. The reality is that the major U.S. oil companies are price takers: Their prices are set by the world market where they contribute smaller and smaller percentages of the world's production.

If the major oil companies are not to blame, what about the speculators? There is little doubt that the number of speculators participating in the marketplace has grown exponentially and that they are responsible in some part for both the speed and magnitude of the recent increases in world oil. Who are these speculators? They are oil-consuming companies, like airlines, that fear prices may go still higher. They are oil-producing companies that fear that the price may fall precipitously and thus "sell" into the futures market. They are brokerage firms and banks that are trying to protect their assets in a market where inflation fears are rising and the value of the dollar is declining. Almost certainly there are some bad actors among the hundreds of speculators, but most are not Enron clones ripping off consumers. They are companies and individuals trying to protect their assets.

So, why are oil prices so high? The answer is simple: Demand is high and supply is low.

Between 1982 and 2002, oil prices were low. Gasoline prices more than doubled between 2002 and 2007, and instead of cutting back, Americans drove more and continued to buy large gas-guzzling vehicles. Part of the reason was that they were a lot wealthier than they were in the 1980s. Thus their change in incomes over the past 30 years was dramatically greater than changes in the value of their oil purchases. With gas at $4.10 a gallon, this situation is finally shifting, and consumers are forced to allocate an ever-growing proportion of their incomes for fuel.

Finally, oil consumption in countries such as China grew faster than GDP. Since the GDP was increasing at rates more than 9 percent per year, China's oil demand was skyrocketing, not just for gasoline to power cars and trucks but for diesel oil to run thousands of small electric generators.

Why didn't supply keep up with the demand growth? In 2004 and 2005, some pundits were predicting that 10 million to 15 million barrels of new oil would come on stream by 2010. Since then, only about 1.5 million barrels of non-OPEC new oil has come onto the market. Ironically, part of this problem is that oil supplies are controlled by state national oil companies that make investment decisions based on criteria that are often less commercial than those used by the major oil companies that we like to berate.

No one knows whether prices will continue to rise, but there are three truths worth considering. Oil prices are volatile, which means that prices that go up rapidly can go down rapidly. The best way to reduce prices is to reduce the rate of demand growth, and there are signs that this is finally beginning to happen. Finally, speculators who bid the price up can also bid the price down, but they will only do this if they believe that the fundamentals are shifting.

If people want lower gasoline prices, they should first identify the true culprits: unsustainable rates of consumption growth and a world oil supply that is unlikely to meet the forecasted consumption levels.

Henry Lee is director of the Environment and Natural Resources Program at the Harvard Kennedy School's Belfer Center for Science and International Affairs.