On The Economics Of High Oil Prices (And Why They Can Be Good)

As we’ve all seen in the UK recently, it costs a lot to fill up at the fuel pumps these days. And as most people are talking about it so much, it’s probably worth sharing a few thoughts.

Why so high?
First let’s examine why oil (and therefore fuel) prices are so high. It’s always largely down to supply and demand, but broken down, the Russia/Ukraine conflict is clearly a big factor, as is the transition from stringent global Covid restrictions to the new ‘living with Covid' phase, where demand shot up and supply couldn’t keep up with that demand. Also, the Covid years saw a reduction in fuel consumption, which hit income for fuel providers, whose increased prices are, in part, to compensate for the pandemic shortfall. Production volatility and capacity at the refineries are a factor, as are increased costs of distribution. The pound’s performance against the dollar is a factor for UK prices. And, also hugely significantly, the government imposes high taxes on fuel, which obviously makes it far more expensive at the pumps. Another significant factor is the ‘climate emergency’ brigade’s war on fossil fuels, which makes oil suppliers nervous about future investment for fear of more stringent green regulations/taxes, which would hit their capital assets.

Price dynamics
Given the foregoing, there are two further things that need saying here about the price increase. The first is that, except for taking off the tax, there is no real way to lower the price of fuel and make the situation better than doing nothing. The second is that, given the truth of the first point, higher prices increase efficiency of consumption. Beginning with the first point; rudimentary economics suggests we can't easily lower the price, because oil is a high-demand but an exhaustible resource. This means that every barrel must be sold at the optimum time for the supplier - if you sell a barrel tomorrow you can't sell it next week, and so on. Deciding when to sell barrels of oil is one of the key catalysts for determining current prices and future prices. And the key inputs to that decision are the current price and the expected future price.

Government activities will generally (but not always) either bid down current prices and bid up future prices, or they will bid up current prices and subject future markets to unwelcome volatility. If the government starts to bid down current prices and bid up expected future prices, they create an incentive for oil suppliers to sell less now and sell more in the future. But this, of course, reduces current supply and goes on to bid up current prices. As a rule of thumb, in a supply and demand free-ish market, the price of oil ought to rise at the rate of interest. This is because leaving oil in the ground is a kind of investment, and investments are generally actuarial analyses tailored to rates of interest. If governments artificially change the price path by reducing current output and increasing the current price, which is what is happening now, then the expected growth rate is diminished relative to projected future interest rates, inducing suppliers to sell more now and not leave it in the ground. Consequently, the very best thing the government can do as a temporary measure to help its citizens deal with the increase cost of fuel is to greatly reduce the fuel tax and offset the loss with temporary reduced public spending in another sector.

Efficient consumption
In the meantime, I said that higher prices increase efficiency of consumption, and here’s why. When the price of a good increases, the people who value it most tend to be the ones who buy it, where the people who don’t need or want it enough to pay the higher prices will either go without or look for a substitute. Suppose there’s a shortage of fuel, and the prices go up because the quantity demanded exceeds the quantity supplied. These price rises discourage casual consumption, and they encourage more production until fuel is readily available again at a more affordable price for more people. If Jeff fills up his car with 60 litres of fuel and sits idly for 2 weeks, and Bob has no fuel and can’t drive his taxi, then the 60 litres have been sold inefficiently. While market volatility isn't a good thing for consumers, if it does happen, like it has in the oil industry, then price increases that reflect the reality of the supply and demand curves are a blessing not a curse, because they cut inefficient consumption (like Jeff’s), safeguard efficient consumption (like Bob’s), and spur on increased production.