Posted on by John Sloman

The surging price of oil: a question of supply and demand

Global oil prices (Brent crude) reached $128 per barrel on 9 March, a level not seen for 10 years and surpassed only in the run up to the financial crisis in 2008. Oil prices are determined by global demand and supply, and the current surge in prices is no exception.

A rise in demand and/or a fall in supply will lead to a rise in the price. Given that both demand and supply are relatively price inelastic, such shifts can cause large rises in oil prices. Similarly, a fall in demand or rise in supply can lead to a large fall in oil prices.

These changes are then amplified by speculation. Traders try to get ahead of price changes. If people anticipate that oil prices will rise, they will buy now, or make a contract to buy more in the future at prices quoted today by buying on the oil futures market. This then pushes up both spot (current) prices and futures prices. If demand or supply conditions change, speculation will amplify the reaction to such a change.

What has happened since 2019?

In 2019, oil was typically trading at around $60 to $70 per barrel. It then fell dramatically in early 2020 as the onset of COVID-19 led to a collapse in demand, for both transport and industry. The price fell below $20 in late April (see charts: click here for a PowerPoint).

Oil prices then rose rapidly as demand recovered somewhat but supply chains, especially shipping, were suffering disruptions. By mid-2021, oil was once more trading at around $60 to $70 per barrel. But then demand grew more strongly as economic recovery from COVID accelerated. But supply could not grow so quickly. By January 2022, Brent crude had risen above $80 per barrel.

Then worries began to grow about Russian intentions over Ukraine as Russia embarked on large-scale military exercises close to the border with Ukraine. People increasingly disbelieved Russia’s declarations that it had no intention to invade. Russia is the world’s second biggest producer of oil and people feared that deliberate disruptions to supply by Russia or other countries banning imports of Russian oil would cause supply shortages. Speculation thus drove up the oil price. By 23 February, the day before the Russian invasion of Ukraine, Brent crude had risen to $95.

With the Russian invasion, moves were made by the EU the USA and other countries to ban or limit the purchase of Russian oil. This increased the demand for non-Russian oil.

On 8 March, the USA announced that it was banning the import of Russian oil with immediate effect. The same day, the UK announced that it would phase out the import of Russian oil and oil products by the end of 2022.

The EU is much more dependent on Russian oil imports, which account for around 27% of EU oil consumption and 2/3 of extra-EU oil imports. Nevertheless, it announced that it would accelerate the move away from Russian oil and gas and towards green alternatives. By 8 March, Brent crude had risen to $128 per barrel.

The question was then whether other sources of supply would help to fill the gap. Initially it seemed that OPEC+ (excluding Russia) would not increase production beyond the quotas previously agreed by the cartel to meet recovery in world demand. But then, on 9 March, the UAE Ambassador to Washington announced that the county favoured production increases and would encourage other OPEC members to follow suit. With the announcement, the oil price fell by 11% to £111. But the next day, it rose again somewhat as the UAE seemed to backtrack, but then fell back slightly as OPEC said there was no shortage of oil.

This is obviously an unfolding story with the suffering of the Ukrainian people at its heart. But the concepts of supply and demand and their price elasticity and the role of speculation are central to understanding what will happen to oil prices in the coming months with all the consequences for poverty and economic hardship.

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Questions

  1. Use a demand and supply diagram to illustrate what has happened to oil prices over the past two years. How has the size of the effects been dependent on the price elasticity of demand for oil and the price elasticity of supply of oil?
  2. Use a demand and supply diagram to show what has been happening to the price of natural gas over the past two years. Are the determinants similar to those in the oil market? How do they differ (if at all)?
  3. What policy options are open to governments to deal with soaring energy prices?
  4. What are the distributional consequences of the rise in energy prices? (see the blog: Rise in the cost of living.)
  5. Under what circumstances are oil prices over the next six months likely (a) fall; (b) continue rising?