Economic Outlook: May 2008

Friday, May 30, 2008

The Status of Oil (Part 1) - History of Increases

The recent increase in oil prices is important for both consumers and investors. In this multi-part series I will present information to help explain why oil is so volatile and important. Part one discusses oil’s recent history. Part two will explore the supply and demand issues clouding our view of oil’s future. Part three will look at global stability, exchange rates, inflation, and other factors that affect oil’s price and increase its volatility. Future installments will discuss specific impacts to consumers and investors, like the recent gasoline price spike and possible hedging strategies.

Unfortunately, the quality of the graphs in the videos is low because of YouTube’s compression and the small screen size. I will post all graphs for you to look at or download here on the blog.

Part 1: Real and Nominal Oil Prices

There are many sources for information on nominal and real oil prices. The most common are the EIA, OPEC, and the IEA. The EIA (Energy Information Administration) provides the official statistics used by the US government. They provide projections, general information and a query system that links to their central database. I used the query system to create a mirror of the EIA’s master database. The information is typically updated monthly, so I will revisit the numbers in a few months to see how they compare to reality.

To calculate the real price of oil, I used CPI numbers with a base of 1.00 in 1982. These CPI numbers came directly from the EIA’s database. I adjusted the prices forward to May 2008 dollars. This way, we can compare prices today directly with those of past years. I would like to have added information on the 1970’s oil shocks, but unfortunately the EIA information doesn’t go back that far. Rather than try to mix sources, I decided to stay with the pure EIA information.

Although I used the CPI to show real prices, it’s also interesting to look at the PPI numbers for the same time period. Since oil is such an important part of the manufacturing process, it’s not surprising that the two are so highly correlated.

We’ve seen how other commodities have increased in price alongside oil. Although the magnitude of these increases is not as great as that of oil, it’s still important to realize that all finite commodities are experiencing upward price pressure. For most consumers, the increase in food prices are the most evident on a day-to-day basis. The reasons for this are complicated and could merit an entire article on their own. The use of corn in ethanol is just one example of the continued stress global food prices will endure. The increases in commodities like gold are more abstract. Investment in gold as a hedge against inflation and currency devaluation combine with scarcity and other psychological factors to push prices up.

For more information on how oil is priced, this article offers a more technical treatment of the subject. Also, for an interesting look at how major oil fields are actually created, this video on the Shaybah oil field in Saudi Arabia shows the development process from the ground up. It also demonstrates the extreme capital investment necessary to access major new oil fields.

Next time, our discussion will shift to the supply and demand issues that have recently come under increased global scrutiny.