Oil Market Prospects--Search for Stability
Authors: Bishop Charles E. 
Published: December 2007

Searching for stability in a commodity market sounds like the pursuit of the Holy Grail. The potential rewards for finding it outweigh the uncertainties of whether it actually exists. Oil consumers and suppliers are investing billions of dollars in pursuit of the flexibility necessary to deal with volatile oil markets. Will the rewards justify these expenditures?

From the point of view of both suppliers and consumers, price volatility is the most persistent reminder of unstable markets. This measure alone, however, is not sufficient criteria with which to judge market stability. That evaluation rests with the institutional adjustments that reject or affirm the long-term oil price structure. The major threat to the long-run price regime is that volume adjustments, which are necessary in volatile markets, are delayed by structural insensitivities associated with demand, the Organization of Petroleum Exporting countries, or the nature of investments in refining and logistics.

Prospects for World Oil Demand

One of the most serious sources of oil market instability in the past several years has been the decline in demand. No commodity can retain a stable value if its use is being eliminated. Since much of this demand decline can be traced to abysmal economic performance, the question of prospective stability lies in an evaluation of potential economic growth. The other demand side element of instability involves the degree of substitution away from oil -- either through more efficient use of labor and capital, or through increased use of other fuels.

Economic recovery is now gathering strength on a worldwide basis. U.S. economic recovery has been and is now in the vanguard; Japan, West Germany, the U.K., and other industrial nations are now reporting growth at a moderate pace.

While OPEC nations are learning to live with restricted budgets, many other developing nations are experiencing improved demand for their exports.

In 1979, the U.S. along with several other industrial nations, turned to restrictive money and credit policies in an effort to contain inflation. After several years of recession, high interest rates and unemployment, some positive results have emerged: lower inflation, higher productivity, economic recovery, and an improved climate for capital investment. U.S. economic growth will average over 4 percent annually during this expansion phase and have positive results internationally. The economic recovery beginning in Western Europe, and continuing in Japan, will gain momentum, and spread to a general global business expansion by mid-decade. Inflation prospects have also been reduced, though not uniformly. The rising volume of trade which accompanies these trends will greatly assist the less-developed countries (LDC's) in managing their persistent debt service problems. Involuntary austerity programs imposed by the International Monetary Fund (IMF), and lower oil revenues in oil-producing countries, will delay significant LDC economic growth until 1985-1986.

However, one major destabilizing force is the strength of the U.S. dollar, which usurps OPEC pricing policy and puts downward price pressures on all commodities traded in dollars. Since other countries must purchase dollars in order to buy crude oil, the local currency cost of dollars is highly relevant to the crude oil pricing structure. Adjusting for exchange rate changes (since January 1983), oil prices are rising for most European nations. Since March 1983 -- after OPEC's sharp downward adjustment -- U.S. consumers have seen little change in their oil price. In contrast, French consumers are paying the equivalent of $9.43 more per barrel, Germans $7.46 more, and the British $5.39 more.