Tag: oil market

Oil prices are determined by demand and supply. Changes in oil prices are the result of shifts in demand and/or supply, with the size of the price change depending on the size of the shift and the price elasticity of demand and supply.

Some of the shifts are long term, with the price of oil varying from year to year or even moving in a particular direction for longer periods of time. Thus the opening up of new supplies, such as from fracking wells, can lead to a long-term fall in oil prices, while agreements by, say, OPEC to curb output can lead to a long-term rise in prices (see the blogs The oil see-saw, OPEC deal pushes up oil prices and An oil glut).

Medium and long-term price movements can also reflect medium and long-term changes in demand, such as a recession – oil prices fell dramatically as the world economy slid into recession in 2008/9 and then recovered as the global economy recovered.

Another long-term factor is the development of substitutes, such as renewable energy, which can reduce the demand for oil; another is developments that economise on power, such as more fuel-efficient vehicles and machines.

But oil prices do not just reflect these long-term movements in demand and supply. They also reflect daily and weekly movements as demand and supply respond to global and national events.

Two such events occurred at the end of August/beginning of September this year. The first was Hurricane Harvey. Even though it was downgraded to a tropical storm as it made landfall across the coast of the Gulf of Mexico, it dumped massive amounts of rain on southern Texas and Louisiana. This disrupted oil drilling and refining, shutting down a quarter of the entire US refining capacity. The initial effect was a surge in US oil prices in late August as oil production in much of Texas shut down and a rise in petrol prices as supplies from refineries fell.

Then prices fell back again in early September as production and refining resumed and as it became apparent that there had been less damage to oil infrastructure than initially feared. Also the USA tapped into some of its strategic oil reserves to make up for the shortfall in supply.

Then in early September, the North Koreans tested a hydrogen bomb – much larger than the previous atom bombs it had tested. This prompted fears of US retaliation and heightened tensions in the region. As the Reuters article states:

That put downward pressure on crude as traders moved money out of oil – seen as high-risk markets – into gold futures, traditionally viewed as a safe haven for investors. Spot gold prices rose for a third day, gaining 0.9 per cent on Monday

Quite large daily movements in oil prices are not uncommon as traders respond to such events. A major determinant of short-term demand is expectations, and nervousness about events can put substantial downward pressure on oil prices if it is felt that there could be a downward effect on the global economy – or substantial upward pressure if it is felt that supplies might be disrupted. Often markets over-correct, with prices moving back again as the situation becomes clearer and as nervousness subsides.

Articles

U.S. crude edges higher, gasoline tumbles after Harvey Reuters, Libby George (4/9/17)
Global oil prices fall after North Korea nuclear weapon test Independent, Henning Gloystein (4/9/17)
Brent crude oil falls after North Korea nuclear test The Indian Express (4/9/17)
Oil prices remain volatile AzerNews, Sara Israfilbayova (4/7/17)

Questions

  1. What are the determinants of the price elasticity of demand for oil?
  2. Search news articles to find some other examples of short-term movements in oil prices as markets responded to some political or natural event.
  3. Why do markets often over-correct?
  4. Explain the long-term oil price movements over the past 10 years.
  5. Why is gold seen as a ‘safe haven’?
  6. If refineries buy oil from oil producers, what would determine the net effect on oil prices of a decline in oil production and a decline in demand for oil by the refineries?
  7. What role does speculation play in determining oil prices? Explain how such speculation could (a) reduce price volatility; (b) increase price volatility. Under what circumstances is (b) more likely than (a)?

The recent low price of oil has been partly the result of faltering global demand but mainly the result of increased supply from shale oil deposits. The increased supply of shale oil has not been offset by a reduction in OPEC production. Quite the opposite: OPEC has declared that it will not cut back production even if the price of oil were to fall to $30 per barrel.

We looked at the implications for the global economy in the post, A crude indicator of the economy (Part 2). We also looked at the likely effect on oil prices over the longer term and considered what the long-run supply curve might look like. Here we examine the long-run effect on prices in more detail. In particular, we look at the arguments of two well-known commentators, Jim O’Neill and Anatole Kaletsky, both of whom have articles on the Project Syndicate site. They disagree about what will happen to oil prices and to energy markets more generally in 2015 and beyond.

Jim O’Neill argues that with shale oil production becoming unprofitable at the low prices of late 2014/early 2015, the oil price will rise. He argues that a good indicator of the long-term equilibrium price of oil is the five-year forward price, which is much less subject to speculation and is more reflective of the fundamentals of demand and supply. The five-year forward price is around $80 per barrel – a level to which O’Neill thinks oil prices are heading.

Anatole Kaletsky disagrees. He sees $50 per barrel as a more likely long-term equilibrium price. He argues that new sources of oil have made the oil market much more competitive. The OPEC cartel no longer has the market power it had from the mid 1970s to the mid 1980s and from the mid 2000s, when surging Chinese demand temporarily created a global oil shortage and strengthened OPEC’s control of prices. Instead, the current situation is more like the period from 1986 to 2004 when North Sea and Alaskan oil development undermined OPEC’s power and made the oil market much more competitive.

Kaletsky argues that in a competitive market, price will equal the marginal cost of the highest cost producer necessary to balance demand and supply. The highest cost producers in this case are the shale oil producers in the USA. As he says:

Under this competitive logic, the marginal cost of US shale oil would become a ceiling for global oil prices, whereas the costs of relatively remote and marginal conventional oilfields in OPEC and Russia would set a floor. As it happens, estimates of shale-oil production costs are mostly around $50, while marginal conventional oilfields generally break even at around $20. Thus, the trading range in the brave new world of competitive oil should be roughly $20 to $50.

So who is right? Well, we will know in twelve months or more! But, in the meantime, try to use economic analysis to judge the arguments by answering the questions below.

The Price of Oil in 2015 Project Syndicate, Jim O’Neill (7/1/15)
A New Ceiling for Oil Prices Project Syndicate, Anatole Kaletsky (14/1/15)

Questions

  1. For what reasons might the five-year forward price of oil be (a) a good indicator and (b) a poor indicator of the long-term price of oil?
  2. Under O’Neill’s analysis, what would the long-term supply curve of oil look like?
  3. Are shale oil producers price takers? Explain.
  4. Draw a diagram showing the marginal and average cost curves of a swing shale oil producer. Put values on the vertical axis to demonstrate Kaletsky’s arguments. Also put average and marginal revenue on the diagram and show the amount of profit at the maximum-profit point.
  5. Why are shale oil producers likely to have much higher long-run average costs than short-run variable costs? How does this affect Kaletsky’s arguments?
  6. Under Kaletsky’s analysis, what would the long-term supply curve of oil look like?
  7. Criticise Kaletsky’s arguments from O’Neill’s point of view.
  8. Criticise O’Neill’s arguments from Kaletsky’s point of view.
  9. Will OPEC’s policy of not cutting back production help to restore its position of market power?
  10. Why might the fall in the oil price below $50 in early 2015 represent ‘overshooting’? Why does overshooting often occur in volatile markets?

As resources become scarce, the price mechanism works to push up the price (see, for example, Box 9.11 in Economics 8th ed). If you look at the price of petrol over the past few decades, there has been a general upward trend – part of this is due to growth in demand, but part is due to oil being a scarce resource. Many millions have been spent on trying to find alternative fuels and perhaps things are now looking up!

Air Fuel Synthesis, a small British company, has allegedly managed to make ‘petrol from air’. Following this, the company has unsurprisingly received finance and investment offers from across the world. However, the entrepreneur Professor Marmont has said that he does not want any company from the oil industry to get a stake in this firm. This doesn’t mean that investment is not needed or on the cards, as in order to increase production of petrol from thin air financing is needed. Professors Marmont said:

We’ve had calls offering us money from all over the world. We’ve never had that before. We’ve made the first petrol with our demonstration plant but the next stage is to build a bigger plant capable of producing 1 tonne of petrol a day, which means we need between £5m and £6m

Whilst the process appears to be a reality, Air Fuel Synthesis is a long way from being able to produce en masse. However, it does offer an exciting prospect for the future of petrol and renewable energy resources in the UK. At the moment oil companies appear to be uninterested, but if this breakthrough receives the financing it needs and progress continues to be made, it will be interesting to see how the big oil companies respond. The following articles consider this break-through.

Company that made ‘petrol from air’ breakthrough would refuse investment from big oil Independent, Steve Connor (19/10/12)
British engineers create petrol from air and water Reuters, Alice Baghdijan (19/10/12)
Petrol from air: will it make a difference? BBC News, Jason Palmer (19/10/12)
British engineers produce amazing ‘petrol from air’ technology The Telegraph , Andrew Hough (18/10/12)

Questions

  1. Explain the way in which the price mechanism works as resources become scarce. Use a diagram to help your explanation.
  2. As raw materials become scarce, prices of the goods that use them to work or require them to be produced will be affected. Explain this interdependence between markets.
  3. Why is investment from an oil company such a concern for Professor Marmont?
  4. Why is there unlikely to be any impact in the short run from this new breakthrough?
  5. If such a technology could be put into practice, what effect might this have on the price of petrol?
  6. How might oil companies react to the growth in this technology?

The price of petrol at the pumps has risen substantially over the past few years. In the UK, according to the AA, the average price between January and June 2011 was 133.13p. In the same period in 2010 it was 116.68p; and in the same period in 2008 it was 109.00p.

Over the first six months of 2011, the amount of petrol sold fell by 5.2 per cent. This was on top of the decline in consumption over the previous four years. Between 2006 and 2010 consumption of petrol fell by 17.4%. The consumption of petrol and diesel are given in the following table.

UK consumption of petrol and diesel (tonnes millions)

2006 2007 2008 2009 2010
Petrol 18.14 17.59 16.68 15.76 14.99
Diesel 20.15 21.07 20.61 20.06 20.87
Total 38.29 38.66 37.29 35.82 35.86

Source: Digest of United Kingdom energy statistics (DUKES) (Department of Energy and Climate Change)

So what has caused this decline in petrol sales? Are there multiple factors at work here? Have a look at the articles and consider the explanations.

Articles
Cash-strapped drivers cut petrol use by 15 per cent Channel 4 News (5/10/11)
Sales of petrol slump as skint motorists cut costs Daily Record, Jamie Grierson (5/10/11)
Petrol Sales Plunge As Cash Squeeze Tightens Sky News (6/10/11)
Fuel cost rise ‘forcing change in driver habits’ TRL News, Mary Treen (6/10/11)

Data
Digest of United Kingdom energy statistics (DUKES) Department of Energy and Climate Change
Fuel price report (monthly) Automobile Association
Brent Crude spot prices Energy Information Association

Questions

  1. What factors have caused a fall in consumption of petrol?
  2. If you choose to spend a set amount on petrol, what is your price elasticity of demand?
  3. What determines the price elasticity of demand for petrol?
  4. Why has the consumption of diesel fallen less than that of petrol?
  5. Under what circumstances would an increase in tax on road fuel of 3p per litre (as planned for January 2012), result in a decrease in tax revenue? Why would the price elasticity of demand for road fuel have to be significantly greater than 1 (ignoring the minus sign) and not merely above 1 for this to be the case?
  6. Why is it likely that people’s price elasticity of demand for road fuel will become less elastic the more they have cut back on consumption?
  7. Why is the demand for petrol likely to be more elastic with respect to (a) price, and (b) income over the longer term?
  8. To what extent is the demand for road fuel a ‘derived demand’?
  9. To what extent is the fall in the consumption of petrol a reflection of a movement along the demand curve for petrol or a shift in the demand curve? Explain.

Oil prices have been rising in recent weeks. At the beginning of October 2010, the spot price of Brent Crude was $80 per barrel. By December it has passed $90 per barrel. There is some way to go before it gets to the levels of mid-2008, when it peaked at over $140 per barrel (only then to fall rapidly as the world slid into recession, bottoming out at around $34 per barrel at the end of 2008).

Higher oil prices are a worry for governments around the world as they threaten higher inflation and put recovery from recession in jeopardy. You will probably have noticed the higher petrol prices at the pumps. If you spend more on petrol, you will have less to spend on other things.

So why have oil prices risen and are they likely to continue rising? The following articles examine the causes of the recent surge and look ahead to the likely response from OPEC and the path of oil prices next year.

Articles
Saudi Arabia to Check Oil Rally in 2011, Merrill’s Blanch Says Bloomberg, Juan Pablo Spinetto (13/12/10)
OPEC Cheating Most Since 2004 as Options Signal Oil Hitting $100 Next Year Bloomberg, Grant Smith and Margot Habiby (13/12/10)
Oil higher after OPEC output rollover; eyes on China Reuters, Christopher Johnson (13/12/10)
Central heating oil price shoots up by 70pc The Telegraph, Harry Wallop (10/12/10)
Speculators driving up price of oil St. Louis Post-Dispatch, Kevin G. Hall (12/12/10)
UK petrol prices reach record high BBC News (10/12/10)

Data
Brent cude oil prices (daily) U.S. Energy Information Administration (use the bar at the top to switch between daily, weekly, monthly and annual prices)
Commodity Prices Index Mundi
OPEC Basket Price and other data OPEC

Questions

  1. Explain why oil prices have been rising. Use a diagram to illustrate your answer.
  2. How can the concepts of price elasticity of demand, income elasticity of demand and price elasticity of supply help to explain the magnitude of oil price movements?
  3. Examine what is likely to happen to oil prices over the coming months. What are likely to be the most important factors in determining the direction and size of the price movements? Distinguish between demand-side and supply-side effects in your answer.
  4. What are ‘crude futures’? Explain how actions in the futures market are likely affect spot prices.
  5. To what extent can OPEC control oil prices?
  6. If crude oil prices go up by x%, would you expect petrol station prices to go up by approximately x%, or by more than or less than x%? Explain.
  7. Why have central heating oil prices risen by around 70% of over the past three months? What are the implications of your answer for the type of market structure in which central heating oil companies are operating?