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by Archives September 28, 2005

With oil prices at record highs in the wake of Hurricanes Katrina and Rita, many journalists and politicians are calling the situation a crisis, and it’s easy to see why. As of Tuesday, roughly a quarter of U.S. refining capacity and oil production remained paralyzed, contributing to the worst disruption of the U.S. energy supply in decades. What’s missing from public debate is a basic understanding of the bigger picture.

What exactly is driving the rise in oil prices? Like any other commodity in our economy, oil functions on the principle of supply and demand. The smaller the supply and the larger the demand, the higher the price will be. Recent events notwithstanding, supply and demand remains the framework of the oil industry, so it’s worth taking the time to understand what’s affecting it.

Let’s start with supply. Are we running out of oil? While we obviously have a limited amount on earth, it’s impossible to say that we’re running out for the simple reason that we have absolutely no idea how much there is. In the early 1960s some experts were predicting that the U.S. would use up all of its oil reserves within 15 years at the rate it was being consumed. Fast forward 15 years, and the U.S. had dramatically increased its rate of consumption, but had larger oil reserves than it did in 1960. Why? Because oil exploration is always uncovering new sources of oil.

The idea that we’re running out of oil also assumes that we’re using all the oil we find. Actually, only about half of the known oil in a given pool is brought to the surface, because the cost of extraction increases the deeper you go. And 30 years ago, it was economically feasible to extract only 25 per cent. That’s a doubling of the amount of oil available to us from known reserves in the space of one generation as our extraction methods became more advanced.

Technological advances and rising prices are also enabling us to extract vast amounts of oil from pools that weren’t considered viable just a few years ago. Take Alberta’s oil sands for example. They represent a pool of oil comparable to the entire known reserves of Saudi Arabia, but the methods and costs of extraction made it unrealistic. Now, with new technology and better methods, this oil is reaching the market.

Finally, most of the people worrying about the price of oil aren’t really thinking about oil at all. It’s gasoline prices they’re worried about, and the cost of crude isn’t the only factor that sets the price at the pumps. It’s possible to have a surplus of oil and a shortage of gasoline at the same time in the same place, if you can’t refine the oil quickly enough. This is a major cause of the gas price hikes, because the hurricanes have knocked out 25 per cent of the United States’ refining capacity.

So supply isn’t as simple as saying we’re running out of oil and aside from the refineries on the Gulf coast, it might not even be significantly contributing to the rising price of gas. What about demand?

This is where things get really interesting. While SUV-driving Americans are a favorite target for those who think we’re consuming too much oil, the biggest factor driving the price up is the huge new demand for oil in the developing world, and China and India in particular. Together they represent about half the world’s population, and as their economies advance through the stages of industrialization, they will suck in an ever-increasing percentage of the world’s oil supply. Already, China is purchasing up to half of the world’s cement, steel and other materials to feed its construction boom, and its oil consumption will increase faster and faster as their middle-class can better afford cars. Forget America and Europe; for the foreseeable future, demand will be driven by the developing world.

With a realistic picture of the oil situation, it’s obvious that there’s little we can do constructively to influence gas prices within the context of a global economy. While we can invest in research and development of new technologies, increase exploration for new pools, encourage consumers and businesses to choose alternative fuels and modes of transportation, and build new refineries, none of that will affect prices in the short term.

Ironically, despite all the complaining from the richest people in the world about the cost at the pumps, high gas prices are the best way of ensuring that all of these solutions will be implemented. High prices give consumers an incentive to conserve and to look at alternatives to gas-fuelled cars and heating. They also make it economically feasible for oil companies to invest in exploration and research, and you can bet that plans for new refineries are already underway.

The best part is that all this will take place naturally without any need for government intervention. That’s just market forces at work.

Neglected Story of the Week: Because it’s been going on so long and the chief negotiating countries have been European, most people on this side of the pond glaze over when the Iran nuclear standoff makes the news. But make no mistake: What happened this Friday was huge. 22 of the International Atomic Energy Agency’s 35 members voted to pass the Iran portfolio to the UN Security Council to consider action against Tehran. This means that the UN’s IAEA and the majority of its member states have given up on negotiations with Iran’s rulers.

While many people say it’s just another meaningless step in this seemingly endless game of cat-and-mouse over Iran’s efforts to get the nuclear bomb, the Iranian leaders probably know otherwise. They need only look next door at Iraq to be reminded that acquiescing to the Security Council’s demands may be their last chance to avoid confrontation and preserve their hold on power.

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