The future course of the oil price

I don't much like supply and demand diagrams, because from a mathematics point of view, they are irritating. The determinant quantity should be on the x-axis, not the y-axis. They are fiddly and look like 18th century schoolbooks on geometry. And what self-respecting economist draws things to sort out their understanding?

Very occasionally, they are fab. Like in determining the future course of the oil price. There is a lot of conjecture about whether the oil price will increase to $200 dollars a barrel by the end of the year. That's where a simple supply and demand diagram can be helpful.

Here's the diagram. The demand curve for global oil is the lower line. As the world economy expands by say 6% a year, the quantity demanded increases by 6% at every price assuming that the new growth is supported by the same oil requirements as the old growth. The demand curves are assumed to be linear; we are interested in short term changes around the equilibrium point, so the assumption is OK. The supply curve is vertical as oil output is not quickly increased, but the curve can slant a bit without changing the analysis.

If demand keeps increasing every year by 6%, then gradually the demand curve will move towards the horizontal, and it will do this more slowly every year. If you think about it, an infinite number of years would be required to reach the horizontal, so it would have to slow down eventually. The price increases also decline if demand increases are the same each year, as the price moves gradually towards its value at the intercept.

The maximum market driven growth in prices (as opposed to politically caused growth) will occur somewhere between now and the time at which world economic growth is at its maximum. Given China and India's path to growth, that time is probably some date in the next thirty years, and the maximum growth is unlikely to be far higher than it is today. So the maximum increase in oil prices is unlikely to be more than its current rate of 25% a year in the near future, at least until supply starts to run out. From the diagram, a gentle rise in price would be expected once supply does dwindle.

Now the change in price depends on the heights and slants of the curves, so a detailed analysis would be required to assess exactly the change in price over time. What we have is recent price change information. Part of the change is a premium due to political events and risk, but they are so closely intertwined with oil pricing that we might say that they should be considered permanent influences on the price. Around 10% growth would be expected in the second half of the year, bringing the oil price to between 140 and 150 dollars a barrel by the end of the year. Oil price is a politically influenced quantity, so there is considerable uncertainty of course, but $145 is my market-based estimate.