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Beating the Oil Barons

WASHINGTON, DC – Over the past eighteen months, oil prices have more than doubled, inflicting huge costs on the global economy. Strong global demand, owing to emerging economies like China, has undoubtedly fueled some of the price increase. But the scale of the price spike exceeds normal demand and supply factors, pointing to the role of speculation – and underscoring the need for policy action to clean up the oil market.

Reflecting their faith in markets, most economists dismiss the idea that speculation is responsible for the price rise. If speculation were really the cause, they argue, there should be an increase in oil inventories, because higher prices would reduce consumption, forcing speculators to accumulate oil. The fact that inventories have not risen supposedly exonerates oil speculators.

But the picture is far more complicated, because oil demand is extremely price insensitive. In the short run, it is technically difficult to adjust consumption. For instance, the fuel efficiency of every automobile and truck is fixed, and most travel is non-discretionary. Though higher airline ticket prices may reduce purchases, airlines reduce oil consumption only when they cancel flights.

This illustrates a fundamental point: in the short run, reduced economic activity is the principle way of lowering oil demand. Thus, absent a recession, demand has remained largely unchanged over the past year.