Price Volatility in Markets - Teacher Presentation
This new revision presentation looks at the causes and conseqences of price volatility in markets - particularly commodity markets. It includes links to relevant news stories which help illustrate the basic demand and supply theory.
Launch interactive version of presentation on Price Volatility in Markets
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OPEC’s biggest cut
The oil export cartel OPEC has announced the biggest ever cut in planned production in a bid to rebalance supply and demand in a market where crude oil prices have fallen by over two-thirds (> $100) within the space of a few months.
OPEC is reducing output by 2.2 million barrels per day – on top of the 2 million contraction in supply announced earlier on this autumn. The total cut in production is equivalent to lowering global oil production by around 15 per cent. OPEC – which accounts for forty per cent of world oil production – has a supply target of 24.845 million barrels per day
It was significant that Russia – the world’s biggest oil producer outside of OPEC was invited to attend the meeting. But in the immediate aftermath of the announcement they said that they will not join the attempts to restrict supply and that they do not wish to consider joining OPEC at this stage. The first reaction of international commodity markets to the OPEC supply cut was to reduce prices still further!
Demand and supply forces
OPEC’s attempts at stabilising the price through lowering output quotas will only have a marginal impact on the world price. Demand-side factors have taken over as the dominant driver of the price of crude oil in the short term and with the global economy set to suffer a recession in 2009 there is precious little that OPEC can do for the moment.
Price and marginal cost – the value of extracting oil from the ground
This short quote from the Saudi oil minister reveals some important microeconomics:
“You need every producer to produce and marginal producers cannot produce at $40 a barrel.”
Extreme price volatility in the markets for primary commodities such as oil, gas and iron ore creates headaches for producers who must commit huge and expensive resources to exploring, drilling, extracting and then refining their basic output
Marginal cost is the change in total cost resulting from supplying one extra unit to the market – in our example, the marginal cost is the expense of extracting an extra barrel of crude oil from below the ground. It is a widely held belief among economists who specialize in commodity prices that the long-run market price of something is determined fundamentally by the marginal cost of production. The resources that can be tapped at lowest cost are often done so first, and then as it becomes progressively harder to unearth such resources the market price must rise to provide an economic incentive to do so.
One immediate problem is that, because oil is a non-renewable resource lying in geological structures that vary enormously in location, weather, depth and many other variables, the cost of extracting new supplies is hard to determine. Many OPEC countries – especially Saudi Arabia – have access to relatively cheap and elastic supplies of oil. But the same cannot be said of crude oil producers in Canada’s tar sands and oil companies who have sunk huge amounts of money into exploiting the oil available in deep-water facilities off the west coast of Africa or in Brazil.
The fact is that for many oil-exporting countries, the price for each barrel of crude oil extracted needs to be higher than the marginal cost of production for national governments to generate sufficient income to pay for ambitious public spending projects.
So whereas the Saudi government can expect to balance its budget when world oil prices are hovering at around $55 per barrel, prices need to be closer to $70 a barrel for the Russian government to earn enough oil revenues to pay for their state spending. And that figure rises to more than $95 a barrel for countries such as Iran and Venezuela.
If prices fall below the marginal cost of production will we see a sharp contraction in supply? Economic theory would suggest yes for, if crude oil prices slump to below $60 or $50 a barrel, petroleum companies with above-average production costs may decide that the price has fallen below the short run shut-down point and opt instead to mothball oil wells, because pumping oil out of the ground has become a licence to lose money.
Indeed the fall in production may be much larger than this – because exploration and development is an expensive business. Oil companies need to know that the price they can command in the market will be persistently above the marginal extraction cost in order to cover the fixed costs of production and the expected rate of profit demanded by shareholders.
It looks like OPEC is targeting a price of $75 a barrel as a ‘fair price’ for oil producers. Given the weakness of the world economy, that might take some time to happen.
Suggestions for further reading:
The Times: OPEC makes largest ever cut to oil production
BBC: OPEC agrees record oil output cut
Sharp fall in commodity prices
Whilst the media’s attention has been focused on the turmoil in the global financial markets, one of the key developments in recent weeks has been the steep decline in the prices of a basket of commodities as measured by the Economist Commodity Price Index. Palladium is down as world car manufacturing starts to contract, the global price of wheat has halved since April, oil prices have declined although steel prices continue to surge higher.
The fall in commodity prices will provide welcome relief for countries suffering from the prospect of stagflation but will also impact on many developing countries whose terms of trade improved sharply when the recent surge in prices took hold.
The links between commodity prices and real economic cycles are well established. But how are commodity values affected by persistent news of financial distress in the money and capital markets?
I have put a selection of price charts into this word file
Another upward spike in inflation
The annual rate of consumer price inflation has spiked up to 4.7% in August - up from 4.4% a month earlier.
The striking numbers this month seem to me to be the surge in the prices of goods with goods price inflation now running ahead of price rises for services for the first year in many a long year. A sharply lower exchange rate, increased manufacturing and shipping costs together with accelerating inflation in many of the lower-cost manufacturing centres of the world are just three of the factors causing goods price inflation to climb above 5%.
The Bank of England has forecast that inflation will climb above 5% in the near term. The good news is that falling world oil prices and a downturn in other internationally traded commodities is likely to bring some relief to interest rate setters as we move through the autumn, giving the Monetary Policy Committee scope for rate cuts starting in October or November.
Inflation affects different people in different ways and few of us experience the same rate of inflation. But the upward movement in the consumer price index is a huge cause for concern.
Latest inflation numbers are available in this powerpoint file
Crude oil heads below $100 a barrel
When the rise in the price of a commodity is described as unsustainable it is probably because it cannot be sustained! The price of crude oil has continued its steep descent in recent days and some futures prices for oil have now dipped below $100 a barrel, presumably a psychologically important moment for the market.
Revision: Stocks and Prices
Many AS microeconomics questions revolve around the volatility of soft commodities such as coffee, crude oil, rubber and tea and harder commodities such as iron ore, copper, tin and platinum. It is important to be aware of the important link between stocks and changes in market prices, especially in an age when commodities have become a new asset class with much more speculative activity than before. Stocks are also important in many other sectors of the economy – for example the property market and the market for carbon permits.
Revision note
Revision_Stocks_Prices.pdf
Powerpoint charts
Stocks_and_Prices.ppt
Chart of the Day: China’s imports of primary goods
We often read about the size of the ‘China effect’ on the demand for and prices of primary commodities traded around the world. This over-simplification ignores the impact that other emerging market economies are having on the consumption of primary products – indeed a much greater proportion of global economic growth is being provided by the resource-intensive emerging economies. Added together, the emerging economies account for 23% of global GDP whereas the US accounts for around 29%.
Chart of the Day: Imported Inflation into the UK
Our chart for the day is linked to the news that the pound has fallen to an historic low against the Euro. One of the consequences of a depreciating currency is that the prices of many of the goods and services we import from overseas goes up potentially leading to a fresh burst of cost-push inflation.
read more...»Revision: Commodity Prices and Economic Effects
In recent years we have seen a sharp rise in the prices of many internationally traded commodities such as oil, gas, iron ore, palm oil, rubber, copper and many foodstuffs. This revision note looks at some of the demand and supply-side explanations for this and also covers some macroeconomic consequences for various countries. This five page revision note available in pdf format (below) will also highlight some micro and macro concepts from the AS and A2 specification and offers ideas for scoring more highly using evaluation.
Mind Map: Credit Crunch
Our A2 macro group mind-mapped the Credit Crunch in a lesson on Friday, a text summary appears below and the original map is also available as a pdf file.
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