Why oil prices are so high: Production shortfall, Iran concerns, and low interest rates

Rising oil and gasoline prices are of concern to many people today. I see three basic issues involved:

  1. “Stalled out” growth in world oil supply
  2. Concerns about Iran
  3. Artificially low interest rates

Stalled Out Oil Supply Leads to Five Million Barrel a Day Shortfall in 2011

In my view, the biggest contributor to high oil prices is the first one–stalled out oil supply.  At this point, the interaction between oil demand and oil supply does not work in the way most people expect it would. Even if the price of oil rises, world oil production doesn’t increase by very much (Figure 1), if at all.

Figure 1. Brent oil spot price and world oil supply (broadly defined), based on EIA data.

In the words of economists, world oil supply is relatively inelastic. This is true, even though the oil supply shown in Figure 1 is what is sometimes called “All Liquids,” so includes substitutes for crude oil, such as biofuels, natural gas liquids, “refinery gain,”  and any fuels from coal-to-liquid and gas-to-liquid processes. These substitutes are not growing by enough to make up for the shortfall in crude oil growth.

If we compare recent oil production with that in the 1980s and 1990s, we see that about 2005, growth in world oil supply suddenly slowed down (Figure 2).

Figure 2. World oil production (broadly defined) based on EIA data, with exponential trend line fitted by author to 1983 to 2005 values.

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