In this section, we examine world crude oil price movements, and analyze the drivers of those price movements. Figure 5 shows monthly WTI crude oil prices over the 2000 – 2010 period, in nominal and real ($2009) U.S. dollars. Nominal and real prices virtually converge by 2008, as there is very little inflation in 2009 with the economic recession.
As figure 5 indicates, we define four sub-periods: a period of relative price stability; a period of increasing oil prices; the 2007/08 oil price shock period, and lastly, the current recessionary period.
The next sections deal with each of these sub-periods, and review in detail the traditional supply and demand crude oil price drivers, the emerging factors, and specific events which influenced oil prices during each sub-period.
Period of Relative Price Stability
During the January 2000 – December 2003 period there was relative stability in the oil market as WTI prices typically varied only $5 or so above or below $30 US per barrel. While the U.S. Glass-Steagall Act was repealed in 1999, the implications for world oil prices of its repeal would not become evident until 2004.
One explanation for this period’s stability was that OPEC’s considerable spare production capacity helped stabilize oil prices into a range that was acceptable for most cartel members. Also, following the September 11th, 2001 attacks there was slow economic growth, lower oil demand, and falling prices.
Period of Increasing Oil Prices
Oil prices started to rise in 2004. According to the IEA, the surge in oil prices since the end of 2003 can legitimately be described as an oil shockFootnote 18, albeit a slow-motion one. The price of oil rose in 29 of the 40 months between September 2003 and December 2006.
One of the largest causes for the run-up in oil prices in the mid 2000s was the sharp rise in demand for oil from China and other Asian developing nations. Between 2000 and 2008, China’s GDP growth rates averaged 10% per year.
High demand from Asia was the beacon that attracted financial investors to the oil market starting in 2004, because oil was seen as underpriced. The price of crude oil, which averaged only $34 per barrel in January 2004, rose steadily. During the Israel-Lebanon war of July 2006, oil prices reached $75 per barrel. Prices fell briefly below $55 per barrel in January 2007 due to a mild winter. Financial investors who speculated on rising prices during this period were richly rewarded. This is the so-called financialization of oil markets. For more information refer to the text on "financializationFootnote 3.
Period of 2007/08 Oil Price Shock
Beginning in 2007, oil prices entered their most volatile period in history. The volatility was characterized by sharp increases in the price of crude oil, immediately followed by equally sharp declines. In our view, this volatility was the result of a combination of numerous background "structural" factors and specific market events, namely:
- the large volume of institutional investment in the crude oil market (financializationFootnote 3);
- falling value of the U.S. dollar;
- Asian oil demand growth;
- the rise of NOCs;
- related hypersensitivity to geopolitical factors (in particular to events in the Middle East, Nigeria and Venezuela);
- rising marginal costs of oil production;
- the established pattern of slow non-OPEC supply growth; and,
- OPEC production cuts Footnote 19
In particular, the decline in the value of the U.S. dollar played a role in the oil spike of 2007/2008. At the time of the oil price peak (July 2008), the U.S. Dollar had fallen to a value of only 0.63 Euros. Although OPEC was concerned about the high price of oil, OPEC was seemingly powerless to control a major spike in prices. The key event which triggered the global recession was rising U.S. house foreclosure rates. One out of every 54 U.S. homes was in foreclosure in 2008.Footnote 22
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