The price of oil has represented a headache for most businesses all over the world and all non-oil producing countries for the last two years. In fact it was about this time of the year in 2004 that oil prices started to rise from the level of around $22 a barrel.
It first hit the $30 a barrel and it was felt that it was a price that could not be sustained. When it hit $40 a barrel, the alarm bells started to ring loudly. It was all for nothing, as the price continued to inch upwards to $50 and then to $60.
Since then it has fluctuated, at times going down to around $55, but it now seems to be settling at around the $60 mark. Maybe it will not settle around this mark and may move further upwards or move dramatically downwards.
It is indeed ironic that, when the price was $22 a barrel, a number of experts and analysts had predicted that the price would go do down to $18. Those must have been their famous last words but they definitely show that it is indeed difficult to predict prices of commodities.
In this country we have had an extensive debate as to whether one could have predicted such hikes in the price of oil and whether one could have hedged against them. In my opinion the whole issue is irrelevant as hedging implies a risk as much as not hedging does. One is only wise after the event. There have been companies and countries that have lost money because they hedged against rises in the prices of commodities (including oil) and there were others that have lost money because they did not hedge.
The relevant issue is whether there is any justification for such prices and whether the current price level is sustainable. In a market that is meant to be nearly perfectly competitive, the price should be determined exclusively by demand.
When we speak of demand for a commodity such as oil, which can be used anywhere and can be transported anywhere, we need to refer to global demand. In turn global demand should be divided between industrial demand and domestic demand. Industrial demand is generated by world output, while the level of domestic demand depends greatly on the level of one's standard of living.
World output has not increased in any dramatic way, as it has kept to the level of growth that we have experienced in recent years. Admittedly, the developed economies did experience a slowdown, starting at end of 2000, and then more so after the events of September 11, 2001.
Eventually some of these economies started to pick themselves up. In the meantime, a number of economic activities were shifted to countries like China and India. However, this has been done more to maintain competitiveness.
In any case, shifts in the location of economic activities do not generate increased demand. Thus the threefold increase in the price of oil does not seem to be justified by any increase in demand resulting from an increase in world output. Putting it another way, the increase in world output did not generate the type of increased demand for oil that would have necessitated a threefold increase in price to equate supply and demand.
The other element is household demand. Household demand is driven by the level of one's standard of living. It is correct to assume that when there is a drop in the standard of living, demand for oil-related products, such as petrol or electricity, is not likely to fall. However, when there is an improvement in the standard of living, demand for oil-related products would increase.
In this regard, as certain economic activities shifted from Western European countries to other countries, this has led to an improvement in the standard of living in those countries that were recipients of this investment and so demand for oil-related products must have increased. On the other hand, it did not increase by an extent that justifies the threefold increase in the price of oil.
The conclusion that one seems to get is that the oil market is not as perfectly competitive as it may be thought and it may well be that the high price of oil that we are experiencing is too comfortable for some countries and is being kept at the $60 level for reasons they know best.
I state this even though analysts claim that the increase in the price of oil in the last two years has been driven by increased demand. They also claim that it is only now that supply considerations may be leading to further increases in the price of oil.
In effect another point to consider is that machinery today is more fuel efficient than it used to be 10 years ago. So increases in world output should not have led to the type of increases in the price of oil that we have had. This is proven by the fact that the fuel price today impacts far less significantly on the final price of the product (albeit with some exceptions) than it ever used to.
Hence, whereas the price of oil is representing a headache for some companies, for several others it may have become slightly irrelevant. This has allowed prices to be pushed higher than ever before and, what is worse, make them seem sustainable.
In the meantime, we, in Malta, sit and wait to see what happens next because for most of us, the price of oil does represent a real headache.