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Special Topic: Oil prices

Oil prices have increased considerably recently, including since we finalised our Budget Update oil price assumption in mid-April.  This special topic discusses our method of forecasting oil prices, the fundamental drivers of the recent increases, the impact of higher oil prices on the New Zealand economy and the long-term outlook for oil prices.  The oil price referred to is for West Texas Intermediate, quoted in US dollars per barrel.

Oil prices reach record highs in real terms

In early July 2008, oil prices exceeded $145, a rise of over 30% (or $35) from the spot price in mid-April when we finalised our Budget Update forecasts.  On a longer term perspective, oil prices are currently at record levels in nominal and real terms, i.e. adjusted for US inflation.  In real terms, the average price in the June 2008 quarter was higher than the previous peak of just over $100 in early 1980 following the second oil shock.

Figure 9 - Nominal and real oil prices
Figure 9 - Nominal and real oil prices.
Source: Datastream

Prices have increased since Budget Update

Our Budget Update forecasts were based on a March quarter average of $98 and average oil futures prices in mid-April.  Prices were assumed to decline from around $110 at that time to $100 by the end of the forecast period in mid-2012.  These projections were approximately 35% higher than our assumption in the Half Year Update in late 2007.  However, spot and futures prices have increased by nearly one third since the Budget Update forecasts were finalised (Figure 10).

Forecasts are based on futures prices

Since 2004, Treasury has based its projections of oil prices on the latest futures prices.  Our analysis has shown that while this approach is far from perfect, it was at least as good as alternatives such as holding prices constant, extrapolating a trend or projecting a return to an equilibrium price.  Futures prices should incorporate all information available to the market about supply and demand.

Figure 10 - Oil price forecasts
Figure 10 - Oil price forecasts.
Source: Datastream

The main drawback of using futures prices recently is that they have generally shown a declining trend from current spot prices during a period when spot prices have continued to rise.  June 2008 Consensus forecasts were for oil prices to fall to $110 in June 2009, with a wide range from $68 to $140 showing the uncertainty of forecasting commodity prices.

Price increases due to demand and supply

Rapid growth in demand, particularly from China and India, combined with slower growth in supply, has resulted in the rapid increase in oil prices.  China’s consumption nearly doubled in the past decade, while India’s increased by more than half.  Rapid growth in oil demand from Asia has been the result of the rapid expansion of those economies and their increasing industrialisation.  Meanwhile consumption has actually fallen in some developed economies (Table 1).

Table 1 - World petroleum consumption
Table 1 - World petroleum consumption.
Source: US Energy Information Administration

World supply of oil and petroleum products increased by slightly less than consumption in the past decade, resulting in a run-down in stocks.  Although supply is sufficient to meet demand, productive capacity has not kept pace, resulting in a decrease in spare capacity and a rundown in stocks, making price more sensitive to changes in supply and demand.  The slow growth in investment in new fields and refineries is a result of the low prices from the mid-1980s until the late 1990s (oil prices averaged $20 in that period), higher costs of investment as more difficult fields are accessed, shortages of skills and capital, uncertainty about future demand (partly because of policy responses to climate change) and disincentives to invest in some countries.

Recently, other factors have compounded the tight market balance.  In many developing countries consumers are shielded from high market prices by fuel subsidies which encourage higher consumption.  On the supply side, geopolitical factors (such as tensions in the Middle East), disruptions in other oil production areas and weather events have added to supply constraints.
The fact that oil prices are quoted in US dollars has also been a factor as the greenback has weakened against the other major currencies in the past 8 years.  Oil prices have risen 340% in US dollars in the past 8 years, compared to 180% in Euro and NZ dollar terms as those currencies have strengthened against the US dollar.

Speculation is also sometimes mentioned as a cause of higher prices.  While there has been higher investment in commodities as other asset classes have underperformed, speculation is not a primary driver of higher oil prices, although it has had some impact.

Positive and negative impacts on NZ economy

The negative effects of higher oil prices on the New Zealand economy are felt through a fall in the terms of trade (i.e. a reduction in international purchasing power and income) and higher fuel prices (with indirect effects on the prices of other goods).  Higher fuel prices lead households to reduce discretionary spending as fuel demand is typically slow to respond to price changes.
On the positive side, New Zealand is now an oil exporter, with exports equivalent to nearly 40% of oil and petroleum imports by value in the past six months.  Oil export revenue is offset by higher investment returns to overseas owners, but New Zealand still gains from local ownership, purchase of local inputs, royalties and taxes.  Higher world oil prices also boost the incomes of net oil-exporting nations and contribute to increased demand for New Zealand’s food exports, e.g. exports of dairy products to Central America.

Prices are likely to decline in the long-term

Oil prices are likely to remain high and could rise further in the near term as demand and supply are relatively unresponsive to changes in price in the short term.  However, prices are likely to fall in the medium to long term as both consumers and producers respond to high prices over time.

Consumers become more efficient in their use of oil and turn to alternative energy sources, while businesses change their means of production.  Oil producers increase supply, including from other sources (e.g. oil sands, bio-fuels), and alternative sources of energy (e.g. solar, wind) are developed.  This delayed response can be seen after the 1970s oil price shocks: consumption declined, alternative energy sources were developed and prices fell by the mid-1980s.

Since prices have been increasing for about five years now, the demand and supply response is expected to occur in the next 5-10 years.  For this reason, we expect prices to fall in the future, but the timing is uncertain.  However, higher costs of production, chiefly as new sources of oil become more difficult to access, make it unlikely that prices will return to the levels of the early 2000s.

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