Tuesday, June 3, 2008

Although OPEC's excess capacity ...

...has rebounded from its 2005 low, the gains are largely in heavy crude oils that can only be processed in specialized refineries. Those facilities are running full bore, so the added supplies aren't relieving a tight market. The latest evidence also suggests OPEC is now restraining its output.

While some warn that oil production has peaked-or will soon-most industry experts contend that oil resources are plentiful; it just takes time and money to get them out of the ground and into the market.

Higher prices have done what economics would predict-stimulated efforts to increase supply. Companies have expanded their exploration budgets. Oil-producing nations have announced new projects. Drilling activity is at a high level, both offshore and on land. Wages and oilfield services costs are being bid up, while shortages persist for some key skills and equipment.

So far, new supplies haven't materialized quickly enough to keep up with growth in world demand, largely because various hurdles have slowed their development. Oil resources, for example, are concentrated in countries with state-run oil companies or little economic freedom. Where market signals aren't allowed to work, incentives to boost production may be muted.

Oil demand is inelastic in the short run-that is, it doesn't react quickly to changing prices. Consumers adjust their spending to maintain consumption as prices rise, even if they have to pay more for it. Most likely, this reflects businesses' commitment to keep up production and individuals' need to drive to work, run errands and heat homes.

When demand is inelastic, even modest tightening in markets translates into strong price movements. In recent years, this inelasticity has magnified tight markets' impact on prices.

-- Federal Reserve Bank of Dallas

No comments: