The price of oil is significantly linked to economic health all over the world. Photo Credit: Stockxchng.com

Starting with the industrial revolution and the introduction of the internal-combustion engine, oil has been an essential factor in the economic expansion of the twentieth century. Its importance has become more pronounced with the spread of transportation and manufacturing. Not all countries can produce all the oil they use however, resulting in two groups: net importers and net exporters of oil. The interdependence between these groups plays a significant role in shaping global economic and political developments.

The Organization of Petroleum Exporting Countries(OPEC), a group of 11 countries,¹ produces close to 40 percent of total world oil production² and owns about 70 percent of proven oil reserves. Other major oil producers in decreasing order of production are the U.S., Russia, Mexico, China, Canada, and Norway.³ Overall, the Middle East, especially the Persian Gulf, remains the major oil-producing region, and holds around 60 percent of the proven global oil reserves.⁴

How Oil Prices Are Determined

Forces of supply and demand determine global oil prices. OPEC's primary goal is to manage market supply by limiting oil production among its members. The objective is to maintain prices that are high enough so that OPEC members make a healthy profit, but not so high that consumers significantly reduce their consumption of petroleum. Because of its production capacity and oil reserves, OPEC's decisions significantly influence world oil prices. However, the power of OPEC to manage world oil prices has diminished in recent years because of increased production from non-OPEC oil producers, such as Russia, Norway and Mexico.

A country's consumption of oil and oil products is closely linked to its level of economic activity and vehicle ownership. Main consumers of oil continue to be developed countries (including the U.S., EU and Japan), but consumption in some emerging developing countries has also been on the rise. This is especially true for China and India, which accounted for 35 percent of the global increase in oil consumption between 1990 and 2003, even though they produced only 15 percent of world output over the same period.⁵

Starting with the industrial revolution and the introduction of the internal-combustion engine, oil has been an essential factor in the economic expansion of the twentieth century.

Global changes in both supply and demand caused oil prices to surge from 10 USD/barrel in 1998 to 50 USD in early 2005.

The rise in demand has come primarily from increased economic activity in Asia (especially China) and North America. Despite the high price of oil, global demand in 2004 was 2.2 percent higher than in 2003. In fact, global oil demand in 2004 grew at the fastest rate in over 25 years.⁶ Cold weather in the Northern hemisphere, which led to an increased use of home heating oil also contributed to this growth.

In 2004, the global supply of oil was affected by fears of OPEC production changes, concerns of possible terrorist sabotage of oil infrastructure, civil conflict in Venezuela and Nigeria, the war in Iraq, and a lack of refining capacity in the U.S., all of which contributed to higher prices. In response to the sharp rise in prices, Saudi Arabia slightly increased its production. Even the Saudis do not have a limitless supply of oil, however, and should prices continue to rise in the future, it may be difficult for them to come to the rescue.

Impact of High Oil Prices on Developed and Developing Countries

All countries are affected by higher oil prices, but the effect varies depending on certain factors.⁷ First, a country that imports a large amount of its oil will generally be worse off than an oil producing country. Second, countries that require a lot of oil to produce other goods will be vulnerable to higher prices. These effects can all lead to reductions in economic activity. The Organization for Economic Cooperation and Development (OECD)⁸ found that a 10 USD per barrel increase in oil prices would result in a 0.5 percent GDP reduction in the world economy. The impact would be more severe for oil-importing developing countries however, because they are more dependent on imported oil, have more energy-intensive economies and are less efficient users of energy. Oil exporters, on the other hand, may benefit from higher oil revenues. Overall, the additional revenues enjoyed by exporters would be outweighed by the economic slowdown in oil importing countries.

The Organization for Economic Cooperation and Development (OECD) found that a 10 USD per barrel increase in oil prices would result in a 0.5 percent GDP reduction in the world economy.

According to the International Energy Agency (IEA), the world will require 60 percent more energy by 2030 than it used in 2004 if energy policies remain the same.⁹ Alarm bells are not ringing yet, and IEA does not expect global oil production to reach its peak before 2030 provided that "necessary investments" are made.

However, given the vulnerability of countries and the global economy to changes in the price of oil, as well as geopolitical reasons, it may be time that the global community think of ways to reduce its dependence on oil through the creation of alternative energy sources at acceptable costs. This is especially important for developing countries, as economic development cannot be achieved without secure sources of energy.¹⁰

---

Footnotes:

¹ OPEC countries include Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela.

² International Energy Agency, Oil Market Report, May 11, 2005. For the most recent issue of the Oil Market Report, available free of charge, please go to http://omrpublic.iea.org/.

³ Department of Energy, Energy Information Administration, "Non-OPEC Fact Sheet." Available online at http://www.eia.doe.gov/emeu/cabs/topworldtables1_2.html.

⁴ For more information on oil and oil markets please see the Department of Energy, Office of Oil, Gas, Energy Information Administration's "Oil Market Basics"

⁵ International Monetary Fund, World Economic Outlook: Globalization and External Imbalances, April 2005. Available online at http://www.imf.org/external/pubs/ft/weo/2005/01/index.htm. Chapter 4 titled "Will the Oil Market Continue to be Tight?" provides a detailed assessment of the longer-run oil market prospects.

⁶ The Economist. "Oil in Troubled Waters: A Survey of Oil." April 30, 2005. Available online at http://www.economist.com/surveys/, but subscription is required.

⁷ International Energy Agency. "Analysis of the Impact of High Oil Prices on the Global Economy." May 2004. Available online at http://library.iea.org/dbtw-wpd/textbase/papers/2004/high_oil_prices.pdf.

⁸ OECD is a grouping of 30 developed countries including Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Korea, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Slovak Republic, Spain, Sweden, Switzerland, Turkey, United Kingdom, and the United States, that tries to address the economic, social, and environmental realities of the globalized economy. For more information please see http://www.oecd.org/about/0,2337,en_2649_201185_1_1_1_1_1,00.html.

⁹International Energy Agency. World Energy Outlook 2004. October 26, 2004. Executive summary available online at http://www.iea.org/textbase/npsum/WEO2004SUM.pdf.

¹⁰ Mandil, Claude. "Energy Policy: No Silver Bullet." OECD Observer, No. 249, May 2005




Contributed by Carnegie Endowment for International Peace. Reprinted with permission from Globalization 101.

To read a Global Envision article about current plans to reduce U.S. oil dependence, see Biofuel Cooperation Marks First Step toward Energy Security.



Return to top