Price of Oil

Engineers cannot not get Nobel prizes. Unlike the semi-science of Economics, Engineering is deemed not at a level that deserves a Nobel prize. In that sense, we are in the same league as another suffering profession, sanitation engineers, aka janitors.

So lets leave Technology and come to try some common sense applied to the pricing of Oil. In the last year we have seen a tremendous peak, followed by a spectacular fall. What drives the price of oil?

Of course, many factors drive the price of a major commodity, some expected and some random. Here I want to describe a very major factor which I think has not received enough attention.

Most oil is now produced and controlled by sovereign countries. When a non-renewable commodity such as oil, or iron-ore for that matter, is offered by these countries, they will limit the quantity offered to their needs of foreign exchange, and no more. The higher the price of the commodity the lower the production needed to obtain the foreign exchange that the producer country needs.

There is a silent agreement from producers, even outside OPEC, to not offer a non-renewable resource when there is no need for dollars. At the current rate of depreciation of the dollar that is fully understandable.

One example of this policy is Saudi Arabia trying to get into aluminum production. This requires high levels of cheap electrical energy usually from hydroelectric sources. Instead, they will use their oil to generate terawatts of electricity to produce this aluminum. You can see that the real objective is to further reduce the supply to the commodities markets. The supply and demand curves do not reflect this effect.

The net result is that when the price of Oil goes up, the production will go down. The reverse is also true. When the price goes down, the production will increase and push the price further down. Of course this a case of positive feedback, a vicious circle. Until a major external event stops the trend, the change in the price of Oil day to day will tend to be in the same direction as the change in price the day before.

Part of this blog appeared in a message I sent to Paul Krugman's blog on June 27, 2008