The froth might continue for a while. Apparently, in the futures market, the natural hedgers have all but disappeared which leaves the place for the speculative buyers. But in the real world, usual supply and demand are starting to exert their influence.

Economics argues that if the price of something rises, the demand for it will fall, and the supply of it will increase, and there are good reasons for these things to happen, normally. However, in the real world, a crucial variable is how fast and to what extent this happens. This has to do with supply and demand elasticities, which are a measure for the extent to which supply and demand react to price changes.

In the oil market, these supply and demand elasticities are low. Meaning that supply and demand are not very price sensitive. It takes a huge price increase to produce any notable effect on the supply of, and the demand for oil.

These inelasticities have to do with the lack of alternatives, especially in the short-run. Consumers of oil often do not have much chance to change their behaviour in the short-term, as alternatives do not immediately present themselves.

Likewise, developing alternative supplies takes time and, above all, money. As we will discuss below, money for investment is part of the problem, especially when increasing the supply of oil itself is concerned.

Over time, supply and demand will adjust more to rising prices, as alternatives increase. Electricity centrals cannot immediately switch to coal or gas, but over time, they might. You might still have to drive a long way to work, but over time, you might look for a job closer to home.

Investment in increasing supply and developing alternatives takes time to come to fuitition, especially since the investors need to be convinced the high oil prices are here to stay if they are going to make a decent return.

These same elasticities also explain why relatively minor shifts in demand and/or supply can produce huge price swings, but that might now come to the rescue

Multiple signs of demand reacting:

• Ford reporting the demand for SUV’s fell by 55% from last year
• Predictions of a mass exodus from American roads
• The rising oil prices contribute to twin economic problems, rising inflation and reducing economic growth in the world economy. Lower economic growth will reduce demand for oil

For a journalist impression on how rising fuel prices cuts traffic, read here.

Demand would react even more if not for price distortions:

• In many countries, especially developing ones and oil producing countries, fuels are heavily subsidized so demand continues unabated and consumers are shielded from price rises. However, this takes a toll on government budgets and the cheap domestic oil are significant opportunity cost for oil exporters. Some countries, like China, are already reducing subsidies
• Funny enough, in some developed countries (Europe), tax on fuel is already so high that the price rises of crude are muted, hence demand is not shrinking to the extent it would otherwise to (compare it to the situation in the US, for instance).

Supply is also reacting, but there are fewer signs here:

• Investment in alternative energy is booming, from that UN 2008 report in the link: “sustainable energy is now a mainstream and an accelerating investment sector”
• Previously uneconomic resources are being explored, like shale gas and tarsand oil in Canada and the US, coal seam gas in Australia, deep ocean resources off the coast of Brazil, and the like.

There are fewer signs that supply is reacting though, and that is understandable:

• Most world reserves are in countries where the regimes use them for political reasons. Not only do they heavily subsidize local consumption (buying support, or spreading the resource wealth, as they would have it), but they’re milking it to prop up budgets and, as a consequence, there is far from enough investment in production capacity and exploration. For instance, Mexico’s Cantarell field, the world’s third largest field, is suffering from declining production (34%, no less, compared to last year) as a result of insufficient investment. A result of the widespread underinvestment is that many countries are not able to increase the output of oil, even if they wanted to
• Some of these players are keenly aware that to increase supply would not be in their short-term interest, due to the inelasticities that would lead to a significant price fall. Some countries seem to positively curtail supply, like Iran, which currently has 11 tankers sitting idle. The logic of refusing to increase supply seems pretty good, but there are two offsetting forces at work here:
• 1) There is a prisoners dilemma at work, the ideal situation for a country with large oil reserves is that everybody else would curtail output, and they alone would sell all they can at the resulting high price
• 2) It’s not in their long-term interest, as long-term elasticities are considerably higher and the high prices will lead to a reduction in demand and the development of alternatives. This will inexorably lead to a loss of pricing power for OPEC, and that’s why the country with the supplies that will last the longest, Saoudi-Arabia, is a moderating force in OPEC. However, few political regimes think about the long-term, and of those that do, few take action accordingly.

With demand, and to a lesser extent, supply, now reacting and world economic growth decelerating, it can only mean one thing. Oil prices are set to come down. It’s not a question of if, but a question of when. We think it will happen before the year is out.

The fact that they have risen so far is mostly due to the fact that the price mechanism cannot do it’s job in large parts of the world. Subsidies and inadequate investments by regimes that exploit their oil wealth for short-term political gains are the main culprits.

Of course, there is always some event that can throw this prediction off, and in no market more so than in the oil market. Any pipeline blowing up by Nigerian rebels, any whiff of increasing tension in the Middle-East, any flaring up of violence in Irak, or the next wild statement from Chavez, they’re all liable to increase geopolitical tensions in senstive areas and lead to predictions gone astray.

But rest assured, the laws of supply and demand have not been suspended in the oil market. In time, the much higher prices will cool demand and increase supply.