Oil Prices in Recent Years, Research Proposal

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This was the clear result of a tightening in supply, however. Another major fuel price shock occurred as a result of the Iranian Revolution and the subsequent Iran/Iraq War. This again caused a supply shock as two of the world's major oil producing nations were completely destabilized (Williams, 2007).

In the 2000s, a number of factors have combined to drive up oil prices. Major economic gains in key, highly-populated developing markets have served to increase demand substantially. The Iraq War has destabilized that nation's oil supply and the Mideast region in general. A weaker U.S. dollar, another consequence of the Iraq War, has also caused the price of oil -- traded in U.S. dollars -- to rise (Ibid). These events correspond with traditional supply and demand drivers. The events of 2008 may have been the result of speculation, but over the course of the past decade, it is more likely that supply and demand are responsible for the run-up in fuel prices.

Conclusion

There are three main drivers to crude oil prices -- supply, demand and speculation. The former are traditional drivers, and can be clearly identified in the context of previous shocks to the price of crude oil. What supply and demand cannot explain, however, is the price of crude oil in 2008. Supply was increasing, demand was falling and yet the price of crude skyrocketed to unheard of levels. This abnormal behavior was the work of speculation in the marketplace. Speculators, by virtue of not actually using oil, only care about spreads, not about prices, which in concert with leveraged trading allows them to drive prices to levels not normally considered tenable.

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There are normal supply and demand factors at work as well. Crude oil prices have increase significantly over the past ten years. This has been the result of destabilization of the Middle East and rapidly increasing demand in developing economies such as China and India. This has been combined with a substantial reduction in price elasticity of demand in the U.S. over the past thirty years, which essentially allows for rapid crude price shocks without significant consequence on demand.

High fuel prices are a political and economic issue of significant import, no doubt in part a consequence of low elasticity. The economy suffers from high fuel prices in the form of reduced spending in other areas. However, OPEC is unlikely to increase production in order to meet the increasing demand from the developing world. Rather, they are likely to take advantage of the low elasticity to reap the benefits of higher fuel prices. The result is likely to be inflation in the U.S., as consumers and businesses adapt to the higher prices. Although the short-term implication is reduced economic activity because savings rates are low and credit is maxed out, over time consumers and businesses will simply adapt to the new high prices and face inflation as a result. There will be future shocks, however, a consequence of speculation, and this will likely serve to increase elasticity of demand, at least back to levels previously seen in the wake of the shocks in the 1970s.

Appendix A: Change in Price Elasticity for Gasoline

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