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Oil Price Shock Cause and Effect

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Industries are forced to scale back production to keep costs in line. Worldwide inflationary pressures push prices higher around the globe. These actions and reactions fundamentally change the way the world works, plays and lives. The necessity of oil drives prices at the margins and the resulting shock pushes consumers and industry to scale back use, limit the demand, and create alternatives for petroleum products. Oil is a commodity that has a demand driven by necessity, is of limited supply, and can therefore be priced at the cost that the last, and highest bidder is willing to pay. This aspect of oil makes it a commodity that is naturally volatile in price. While the news and fear mongers warn of a worldwide oil shortage and a bottleneck in refinery capacity, this alone cannot explain the sharp increase in prices. In 2007, the world demand for oil was 85.7 million barrels per day and a refinery capacity of 85.4 million barrels per day (Doggett 2008, Worldcrudeoilrefiningcapacity 2007). In addition, the modest increases in demand have been linear and not a reflection of the volatile spikes in price. Saudi oil minister Ali al-Naimi recently stated that there were no discrepancies in supply and demand and said, "There is no justification for the current rise in prices" beyond psychological and speculative (QD. in Roberts 2008). Though demand closely approximates supply, small disruptions, or threats to the supply in the system, can lead to the creation of an artificial demand on the supply. Hurricanes, wars, and natural disasters all contribute to a climate of fear. Because oil is a necessity priced at the margins, it requires a relatively large increase in price to decrease the demand significantly. This allows oil prices to fluctuate wildly in a volatile market. Oil futures markets have allowed speculators to create an artificially high demand for petroleum. Futures contracts were originally designed to stabilize prices by guaranteeing a producer a price and ensuring a given level of production. However, oil futures traders have used the system to speculate on pricing and have a self-interest in driving prices higher. According to Roberts (2008), "In an effort to forestall a serious recession and further crises in derivative instruments, the Federal Reserve [US] is pouring out liquidity that is financing speculation in oil futures contracts". Hedge funds and investors are financing falling profits through highly leveraged futures contracts in the same way that the housing bubble was built upon the practice of flipping homes (Roberts 2008). Engdahl (2008) contends that, "As much as 60% of today’s crude oil price is pure speculation driven by large trader banks and hedge funds". These futures contracts, largely unregulated, add to an artificial demand in the marketplace and force prices higher. However, as long as there are some market forces at work, this oil bubble will collapse the same way the real estate market has. In fact, as of this writing in October 2008, oil has fallen to 60 percent of its record high. The major effect of the escalating price of oil is the inflationary pressure that it places on the consumer, and the resulting economic slowdown. The most apparent and direct result of the high cost of oil is the rapid rise in the price of gasoline at the pump.

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