Ask the blogger

A reader writes:

I would like to see you do an article about the current oil prices. I am no economist but have a basic question. If oil production is about the same as three years ago and oil refineries are running at about the same capacity (maybe less due to Katrina, political unrest, etc.) , why is the price of oil more than double from three years ago? I know that the demand for gasoline is probably up which would certainly explain higher gas prices but it would seem that a relatively fixed refinery capacity breaks that relationship between oil and gas prices.

Three reasons:

1) Rising world demand Rising incomes in Asia are pushing up demand for oil to power transportation and industry.

2) Supply worries When investors worry that future oil prices will be high due to a supply disruption, they bid up the price now and stockpile. No one's quite sure how much this speculative aspect plays a role. But security worries in Iraq and Iran, civil unrest in Nigeria, Saudi Arabia's simmering problems, and Hugo Chavez's populist antics with PDVSA, the Venezolano state-owned oil company, all have people worried.

3) Supply inelasticity Pretty much every country on earth is pumping as much oil as they can except Saudi Arabia, and it's very unclear how big even their cushion is--certainly no more than a couple of million barrels a day in a world thirsting for the hundred million mark.

We don't know whether these worries are permanent or short term. One argument says that OPEC nations have been grotesquely exaggerating their reserves in order to raise their OPEC quotas, and that therefore we are at or near the natural limit of the oil that can be economically pumped. Another argument says that countries, especially OPEC nations, are simply slow to ramp up their capacity because they are still haunted by the memory of the price collapses in the 1980s and 1990s, which devastated their economies and politically threatened many oil regimes. It's worth noting, however, that one of the main oil supply bulls is now predicting that oil will hit $150 a barrel.

In the short term in the US, the main constraint is refinery capacity, especially in small regions with their own boutique mixes, such as Chicago. Over the longer term, the constraint is willingness of various places to build processing plants for our gasoline, port capacity to handle transshipment, and of course, how much we're willing to pay for the oil that goes into our gasoline.

Either way, I'd look for prices to stay high for a while. Of course, bubbles always look most solid right before they pop, so take that for what it's worth.