Explaining oil price dynamics

The price dynamics of oil and other non-renewables is a complex field of theoretical and empirical analysis. The Analysis takes the Hotelling rule as an analytical point of departure - basically relevant for the supply-side dynamics - and also considers resources demand, which is assumed to negatively depend on the price of oil and positively on net real wealth of the private sector (wealth and real income are, of course, related to each other through the interest rate). The net wealth variable is of particular interest in the approach presented, which emphasizes, that pricing of non-renewable resources should be considered in the context of portfolio analysis and the role of wealth, respectively. The fairly standard assumption, that the change in the price of natural resources per unit of time is a positive function of the excess demand in the oil market, implies a differential equation, which shows how crucial the role of oil inflation expectations are. If those expectations are below a critical level, there will be stable long run oil price. If, however, the expected oil inflation rate exceeds the critical value, there will be an ongoing increase of the oil price. From this perspective, it is clear that the long run price developments of natural (non-renewable) resources are strongly shaped by global expectation dynamics. To the extent that global real demand shocks or restrictive shifts in monetary or credit expansion dynamics occur, oil inflation expectations could switch from the range of above the critical inflation expectations to below such range, which then amounts to a price regime shift. Such a shift obviously has occurred during the transatlantic banking crisis and the following global recession. A somewhat alternative short-term analytical approach considers oil pricing in the context of a broader portfolio model - thus, oil and several standard financial assets are considered. Policy makers should consider both volatility issues and the challenges of sustainable growth.