[Footprint] Oil Prices and Alternatives

With oil prices hitting a new record high today ($64 per barrel) and bearing in mind that the pound isn't as high against the dollar as it has been (making that $64 even more expensive) I thought that it would be worth posting a couple of recent thoughts about pricing.

For all commodities supply and demand inequalities will push prices lower and higher around the cost of production. The cost of production is effectively the amount of manpower that it takes to produce the good. So as demand for oil goes up then the prices go up but in response production should go up - now we haven't got to that last stage yet, and in fact we may never see production of oil go up again.

Let's make a small revision to that economic statement - prices will hover around the cost of production where there are alternatives. e.g. if the cost of potatoes goes up then more people will switch to parsnips (an alternative) and bring the price of potatoes back down. Or indeed, the cost of potatoes will go up until an alternative producer is found to produce them.

However, for many applications oil doesn't have a cheap alternative. Take diesel cars for example - the obvious alternative is bio-diesel. The problem here is that bio-diesel cost much more, it only becomes an alternative commodity and therefore only moderates the price of oil when the oil price goes particularly high.

Oil is so important because there are few alternatives that are anywhere as cheap for the uses we put it to. Transport fuels are probably the best example because, whilst you can use batteries or perhaps fuel cells, they are both very expensive alternatives.

An alternative for heating oil is coal as there is a whole load more coal in the ground than oil, but mining and distribution (let alone pollution) costs don't make it the ideal alternative.

So don't expect the simplistic rule of demand bringing more supply to work too smoothly with regards too oil. The rule must be qualified with the concept of 'alternatives' - which in this case just isn't going to help us out too much!