Find data on oil price changes over the last decade or so, and present the data on an appropriate graph. Comment briefly on the trends shown by this data.
The graph and table (pp3-4) track the monthly average cost per barrel, US Dollars, of West Texas Intermediate oil, “the principal benchmark crude” (The Economist, 2005).
The increases seen during 1999 and 2000 can be explained by the Organization for the Petroleum Exporting Companies (OPEC) reducing supply. However, the effect of emerging economies, in particular China, was starting to be felt (Begg D, Fischer S, and Dornbusch R, 2008b). In the following year (2001), the effects of a slowing world economy were being seen, hence the price decreases (Sloman J, 2007).
These decreases were exacerbated by the major terrorist attacks in the US on 11th September 2001, now universally referred to as 9/11 which led to a decrease in air travel (Burdette M, 2009) although the immediate impact (24 hours) was minimal (Energy Information Administration, 2009).
The price increases in the years up to 2006 can mainly be put down to increased demand, especially from China. BP's 2009 statistical review of world energy shows China's consumption rising 40%, from 5288 (2002) to 7382 (2006) thousand barrels daily in the period as compared to the UK, for example, where there was an increase of 5% from 1693 to 1785 thousand barrels daily (BP, 2009).
There were, however, some natural events that also added an upward price pressure due to their effect on supply; the Tsunami on Boxing Day 2004 and Hurricanes Katrina and Rita in 2005 (BBC, 2005). Hurricane Katrina cut US crude oil production by nearly one million barrels per day but the International Energy Agency (IEA) reacted by releasing oil stocks to counteract the effects (Parkin M, Powell M, and Matthews K, 2008).
In addition to this has been the effect of the Iraq War. The uncertainty of possible disruption to supply both before and during has had upward pressures (Congressional Research Service, 2005, pp.226-230).
The steep decline in prices from the summer of 2008 is undoubtedly due to the worst worldwide recession for decades (Seager A, 2009) although prices of late have seen some recovery.
2. Using the Supply and Demand framework, explain the main factors that may account for the price changes shown by your data.
Supply and Demand is a basic principle of economics and, indeed, was talked about by Adam Smith in his iconic text, Wealth of Nations, before the term economics was in common usage. Smith talked about an “invisible hand” when explaining that an individual will act with self interest when making purchases and, in the case of a trader, pricing decisions (Smith A, 1993).
This self interest is a critical concept. Quantity demanded is deemed to be that amount of a good or service that a consumer is able and willing to buy at a given price. In conjunction with this, supply is the amount of a good or service that a firm is willing and able to supply at a given price. At a lower price, more will be demanded of a good or service than at a higher price and conversely, the higher a price, the more a supplier will be willing to supply (see Fig. 1 p9) (Begg D, Fischer S, and Dornbusch R, 2008a).
In economics rather than using the terms shortage or excess, one says quantity supplied exceeds quantity demanded (excess) or quantity demanded is greater than quantity supplied (shortage). The point where quantity demanded equals quantity supplied is known as the equilibrium price (Begg D, Fischer S, and Dornbusch R, 2008a).
Frank (2008), talks of the economic model of supply and demand being, “a story about the forces that determine which products get produced in which quantities at what prices” (Frank R, 2008). Put simply, “there is no “over” or “under” supply, there is only the price at which the market clears” (Saunders K, 2007).
Apart from price there are several determinants of demand; taste, substitute goods, complementary goods, income and expectations of future price changes (Sloman J, 2006):
- Taste has a number of variants including previous consumption, fashion, advertising, media exposure, health and wellbeing and peer pressure.
- Substitute goods are those goods that a consumer will start consuming in preference to another if the price of the original increases. A complementary good is one that is consumed along with another eg. bread and jam and the price increase of one may well decrease demand of the other.
- Generally speaking, as a person's income rises so their demand for “normal” goods increases and that for inferior goods fall. Examples are a cheap greetings card or “value” foods.
- A consumer may put off making a purchasing decision, or buy less in the meantime, when there is an expectation of a future price decrease. The converse also applies.
With supply, there are also a number of determinants other than price; production costs, substitutes, profitability of jointly supplied goods, nature, expectation of future price changes and the number of suppliers (Sloman J, 2006):
- The costs of production can change for a number of reasons including raw materials, technology, organisational change and government action. Generally, as costs rise so a firm will cut back on production of that good.
- Where more than one good or service is supplied there will be a tendency to increase production of another good if its profitability increases above that of the original, be it a substitute or one that is in joint supply.
- Nature can affect the supply of goods by reducing capacity or destruction of raw materials eg. earthquakes, weather and disease. Industrial disputes can also reduce production.
- A supplier will reduce production or fail to release products for consumption where it expects there to be a future price increase
- There is likely to be an increase in supply as new firms enter the market.
The other term that needs exploring before we relate this information to oil is “elasticity”.
This refers to the amount by which demand for a good will change following a decrease or increase in price. We talk of goods being elastic or inelastic dependant on the effect of the change. For example, carrots are elastic because if there was an increase in price consumers would be likely to purchase substitute items instead ie. other vegetables. Where a good is inelastic, a change in price would have little effect on quantity demanded and oil, with which this question is concerned, is deemed inelastic, at least in the short run, because given an increase in price the quantity demanded would stay very much the same. People would continue to use their cars and industry would continue to consume similar amounts in order to meet its expected production (Begg D, Fischer S, and Dornbusch R, 2008c).
When it comes to supply, elasticity is the responsiveness of the quantity supplied to a change in the price. Where there is elastic supply an increase in price will lead to a corresponding increase in supply. Where supply is inelastic due to, for example, the inability to change short term production, then a price rise will have little effect on supply (see Fig.3 p10) (Begg D, Fischer S, and Dornbusch R, 2008c).
Turning specifically to oil, “crude oil prices behave much as any other commodity with wide price swings in times of shortage or oversupply” (Williams J L, 2009). Saunders takes this further, however, explaining that in the short term, oil is unusual in that both demand and supply are highly inelastic (see Fig. 2 p9), but in the long term they are elastic in that given sustained high prices consumers and/or governments look to alternatives (fuel efficient cars, transport infrastructure) (Saunders K 2007).
The oil market while behaving most of the time as any other commodity has four unique features that come into play at different times and to various extents (Congressional Research Service 2005).
Firstly, there is OPEC whose stated intention in its original statue was to, “devise ways and means of ensuring the stabilization of prices in international oil markets with a view to eliminating harmful and unnecessary fluctuations” (OPEC, 1965).
It admits a common misconception is that it sets the price of crude oil (OPEC, 2009a) but it does inform us that indeed member countries coordinate their supplies in order to bring stability to the market by matching production to expected demand (OPEC, 2009b).
That there are influential companies and, even nations, is confirmed by Hoyas (2007) who named the “New Seven Sisters” of oil production who between them produce over 20million barrels of oil per day (Hoyas C, 2007). However, how to influence the price is not that simple. Indeed, the Energy Information Administration's guide to “Oil Market Basics” contains six chapters and links to 400 external websites! (Trench C, 2009).
The second factor is the disruption of supply due to technical issues caused, for example, by natural phenomenon (see Fig. 4 p10), or political instability eg. Nigeria (The Economist, 2009, pp.31-34) (Omeje K, 2006).
The third factor is harder to calculate, being a fear of the unknown outcome of perceived global threats such as terrorism or war (Congressional Research Service 2005).
The fourth factor to be considered is that the exchange rate of the US dollar can affect the price of oil because it is priced and generally paid in this currency but the effect may differ between nations (Congressional Research Service 2005).
Although, clearly, there are attempts to set or, at least influence, the price of oil and other unique factors of the oil market are at hand, one only has to read the notes to a slide of Shore's (2004) presentation to the Oil Price Information Service (OPIS) summit when commenting on the reason for strong prices, “This was a surprise to almost everyone - suppliers and consumers” (Shore J and Hackworth J, 2004) to realise that the “invisible hand” is undoubtedly at play.
When oil prices rise significantly “economic illiterates” assume collusion, government action or power wielding monopolies but nothing could be further from the truth. This is proof of the market forces of supply and demand and competition at work (Landsburg S, 2007).
Total Word Count (excluding headings, graphical information and bibliography): 1654
The diagram shows the demand and supply curves. Demand and supply both vary with price ie. If prices go up, demand will fall but supply will increase and if prices decrease, demand will rise and supply will diminish.
The next diagram is representative of the oil market in the short term. As both demand and supply are inelastic they have steep curves as a large change in price leads to a relatively small decrease in demand.
This diagram shows a shift of the demand curve to the right with a resultant sharp price increase. An example of this behaviour would be an emerging market, such as China.
This diagram shows a shift to the left of the supply curve with a resultant rise in price. This can be caused when there is a sudden decrease in supply caused by, for example, a hurricane closing down a refinery.
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