This year the world will consume about 89.3 millions of barrels of oil per day, and only about 2 million of those barrels, about 2% of the total, will come from Libya.  Why then, did oil prices spike by 22% when the Libyan revolution started?  The answer lies in the relationship between consumption and production, or to put it in more basic terms, demand and supply.

Oil demand has been growing over the past two years as the developed economies have come out of recession and as China has increased its imports.  Producing nations have strained to keep up.  The notion that Saudi Arabia or Iran can simply turn some valves and increase production by a few million barrels of oil per day is a fantasy.  In fact, the major oil producers are going pretty much flat out and any increase in production requires an investment in infrastructure and some lead time.  When demand and supply are so tightly balanced, the prospect of losing even 2% of the supply for a protracted period is enough to send speculators into a feeding frenzy, and that is exactly what happened in the past two weeks.

We have been here before.  There have been six significant “oil shocks” in the past fifty-five years.  The most significant was the Suez crisis of 1956 which reduced world oil output by 10%.  The OPEC oil embargo of 1973 reduced production by 7.5% and the destruction of the Kuwaiti oil fields in 1990 cost the world 9% of supply.  In each of the these cases, and in fact in all six cases, other producers were able, over time, to make up the shortfall.  The situation with Libya is of course much less serious – a possible 2% drop in output is not really comparable to the significant drops noted above –  but the combination of growing consumption and the difficulty of increasing supply resulted in the extreme volatility in oil prices.

All of us have seen the prices for gasoline shoot up, and a natural question is the extent to which this will hurt the economy.  Economists have calculated that a $10 per barrel increase in the cost of crude reduces the U.S. gross domestic product by about .2%, since consumers have less money to spend on everything else.  Since the U.S. economy is growing at about 3% per year, this is not a huge hit, but it is still unwelcome.  Depending on how things play out in Libya over the next few months, the price of oil could remain near $100 per barrel.  If so, this will be a headwind slowing economic growth.  The worry, of course, is that a major producer such as Saudi Arabia (12% of world production) or Iran (5% of world production) could become subject to the same revolutionary fervor that has swept North Africa.  If that happens, all bets are off, and one can expect the price of oil to soar to unpredictable heights.