Oil prices – what supply shock?

If prices go up, demand should go down, right? This is not the case for many countries where the governments subsidize energy. Demand has moved with overall economic growth and been insensitive to the world price of crude. The combination of lower prices not attached to market movements and strong growth has caused higher demand for gasoline. The world is not facing a supply shortage but a demand shock. The current supply cannot keep up world demand. Of course, part of this problem is always supply. Capacity utilization for OPEC oil is down from its high, but if the cartel is wrong about their demand estimates, that is, there is a demand shock, there will be a spike in prices. It takes some time to increase production.

Governments are trying to put market forces back in place by raising the price of gasoline. China announced a price increase of 10% on gasoline because they are in the extreme position of seeing shortages. These shortages are not from the high price but from cut in refining. The refiners take it on the chin when crude prices rise. They buy on the open market and then have to sell at the subsidized price without being compensated by the government for the difference. You cannot make it up with volume, so you might as well cut refining production.

Most of the BRIC’s have subsidized oil prices. Nevertheless, India is also thinking of raising prices. Gasoline is subsidized in OPEC countries which have also seen significant growth. Prices of gasoline in Iraq and Iran are less than 50 cents a gallon. These drivers have not felt the pain of higher prices. (It was reported that Hummer sales in Venezuela were strong because of cheap gas prices.) McKinsey has actually concluded that if subsidies were eliminated in many developed countries the savings would be approximately 3 million barrels a day.

Market forces will allow for demand to decline and force prices down. Any changes in pricing in developed countries will cool the oil market. Look for any news of changing government policies as means of reducing the demand shock.