Why the Price of Oil Is Rising

It’s hard not to notice rising gas prices as we head to the pumps—and they have indeed been climbing. A year ago, a gallon cost about $2.40; now it’s closer to $3. The price of oil is at the root of that rise, of course, going from about $45 a barrel to around $70 in the same time period.

What’s at the root of the rise in oil prices? It’s a mix of politics and economics—and supply and demand—explained Gilbert Metcalf, a professor of economics at Tufts. He tackled the subject in a recent posting on EconoFact, published by the Edward R. Murrow Center for a Digital World at the Fletcher School.

While oil prices have risen significantly, there are checks and balances, Metcalf noted. For instance, when prices rise, U.S. shale oil producers can quickly increase production, to take advantage of those price increases, and, by adding to the supply of oil, moderate them.

Metcalf, who does research in energy economics and served as deputy assistant secretary for environment and energy at the U.S. Department of the Treasury in 2011-2012, recently spoke with Tufts Now about the oil economy.

Tufts Now: Oil prices have been steadily rising for the past year. Why is that?

Gilbert Metcalf: OPEC, along with Russia, agreed to curb production in early 2017 to prop up global oil prices. They’ve not been very successful at that, however, since many of the OPEC countries, as well as Russia, have fallen short on agreed production cut-backs. The real reasons for the price rise are the collapse of the Venezuelan economy and Trump’s decision to renege on the Iran nuclear deal. 

What is the connection with the Venezuelan economy?

Nicolás Maduro, the increasingly dictatorial leader of Venezuela, has led the country to economic ruin. Venezuela’s national oil company, PDVSA, was historically led by highly respected technocrats and oil engineers, and contributed greatly to the country’s wealth and prosperity.

Hugo Chavez, Maduro’s predecessor, interfered in the oil company’s operations and managed to drive away much of the senior leadership. Maduro has accelerated the slide. The country’s fiscal situation is so dire that PDVSA can’t make needed investments to maintain its aging infrastructure. The result is a precipitous decline in oil production, which started in mid-2015 and saw production fall in three years by one-third. Just in the last twelve months, Venezuela’s production fell by more than 400,000 barrels per day, the largest decline among all oil-producing countries.

And the Iran deal connection?

In addition to Venezuela’s production demise, the Trump administration’s decision to withdraw from the Iran nuclear deal and again impose sanctions jolted global oil markets. Since the nuclear deal was signed, Iranian production has increased by nearly one million barrels per day. Analysts think the re-imposition of sanctions will cut Iranian production by less than 500,000 barrels per day, but there is much uncertainty, with analyst estimates ranging between 100,000 and 800,000 barrels per day.

Meanwhile, the global economy is strengthening and fueling higher demand for oil. Given that growing demand and the time it takes to bring new oil on-line in response to higher prices, it’s no surprise prices have risen. 

What is the economic impact of that rise in oil prices on both the U.S. and global economies?

It’s a mixed bag. Consumers are paying more for gasoline at the pump. Regular gasoline is about $3 a gallon in New England right now. That’s up about 25 percent from a year ago. But households spend less on gasoline as a share of their income than they did in the early 1980s, when it was about double the current share. That’s because prices are lower today in real terms, and cars are more fuel efficient.   

Higher prices are also good for oil producers in Texas and North Dakota, where the shale oil boom creates lots of drilling jobs.

Oil prices declined earlier in the decade as a result of increased production in the U.S.—as prices rise again, will that cause a bump in U.S. oil production, as it becomes more profitable for domestic producers? If so, will that stabilize oil prices, or even lower them?

Shale oil from Texas and North Dakota can be ramped up relatively quickly. This will put a brake on the rise in oil prices. One reason for OPEC and Russian restraint in curtailing demand and driving oil prices up is the recognition that high prices will trigger major increases in U.S. shale production, something OPEC and Russia would like to avoid.

The price is obviously a result of supply and demand. How does the demand side look—does the global economy look like it will continue to expand?

The global economy is doing quite well at the moment, despite the uncertainty over tariffs and the possibility of a trade war between the United States and its various trading partners. The IMF’s most recent World Economic Outlook sees growth in developed and developing economies continuing at a robust pace for the next few years. Economic growth drives up the demand for oil. That’s why modest production declines in Venezuela and Iran can have outsized influences on global oil prices. 

Cheap oil has been a disincentive to move toward more sustainable energy sources—do you see the current rising oil prices as a boost for development of more sustainable energy sources?

Higher oil prices create incentives for energy efficiency and biofuels, but only if the higher prices persist. A short-term blip in prices won’t have much impact on sustainable energy sources. Also, keep in mind that the major forms of renewable energy—wind and solar—are not good substitutes for oil right now. Oil is predominantly used in transportation. Wind and solar generate electricity. Only when we see a major penetration of electric vehicles in transportation will wind and solar begin to displace oil in a major way.

Taylor McNeil can be reached at taylor.mcneil@tufts.edu.