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AS Markets & Market Systems

Market for Oil

The effects of changes in the price of crude oil traded on the international petroleum exchanges can be far-reaching, not just for the British economy but for the global economy too. A basic study of the oil market is a useful application of the principles of supply and demand analysis and a way of understanding the interconnections between the microeconomics of the oil market and their macroeconomic consequences.

Market theory in action - what determines crude oil prices?

Oil is one of the most heavily traded commodities in the world. Fluctuating prices have important effects for oil producers/exporters and the many countries that remain dependent on oil as a key input in their energy, manufacturing and service industries.

The demand for oil

1. Cyclical demand: There is a strong link between the demand for oil and the rate of global economic growth because oil is an essential input into many industries – when the economy is expanding, the demand for oil rises. The best recent example of this is the growth of the Chinese economy. Fast growth of national output in energy-intensive sectors has led to a surge in demand for crude oil into the Chinese economy.
2. Prices of substitutes: Demand for crude oil affected by the relative prices of oil substitutes (e.g. the market price of gas). If, in the longer term, reliable and relatively cheaper substitutes for oil can be developed, then we might expect to see a shift in demand away from crude oil towards the emerging substitutes. The high price of oil during 2004-2006 seems to have led to a rise in research and development into non-oil substitutes. These can take several years to come through to affect the market for energy.
3. Changes in climate – e.g. affecting the demand for heating oil. It is often said that if the winter in North America is fierce, then the price of crude rises as the USA and Canadian economies raise their demand for oil to fuel household heating systems and workplaces
4. Market speculation: There is always a speculative demand for oil (i.e. purchasers hoping for a rise in prices on world markets). Indeed one of the features of the most recent spike in oil prices has been the high level of demand by hedge funds and other investors pouring into the international petroleum exchanges to buy up any surplus oil futures contracts. They hope that by the time the contracts are ready to be fulfilled, they will have made a large profit. Speculation involves risk, prices can do down as well as up.

Who are the main consumers of oil? Nearly two thirds of global crude oil production is consumed by the leading industrialised nations – i.e. the nations that make up the Organisation of Economic Cooperation and Development. But a rising share of oil demand is coming from the emerging market economies including China, Brazil, Russia and India.

The supply of oil

When we consider the global supply of oil we need to make a distinction between short-term and longer-term supply to the international markets. The short run supply curve is normally drawn on the basis of a given state of production technology and fixed use of capital inputs (i.e. the oil industry is supplying from a known level of oil reserves and a given stock of capital machinery used to extract that oil). There is inevitably a short-run limit on daily oil supply and, as production gets close to capacity limits, so the short run supply of oil becomes more inelastic.

One possible way of modelling this is to assume the market supply curve for oil is non-linear (shown in the left hand diagram below). An alternative is to suggest that more oil can be supplied elastically at a fairly constant price until the capacity limit is reached, when the short run supply curve becomes vertical.

In short, the short-run supply of crude oil is affected by a series of different factors

1. Profit motive: The production decisions of OPEC and Non-OPEC countries (see revision notes on OPEC below)
2. Spare capacity: The level of spare production capacity in the oil sector
3. Stocks: The current level of crude oil stocks (inventories) available for immediate supply from the major oil refineries – i.e. a high level of stocks means that extra oil supplies can be released onto the market quickly when demand fluctuates
4. External shocks: The effects of production shocks (e.g. loss of output from rig closures or disruption of oil supplies due to war and terrorist attacks)

Taking a longer-term perspective, the long run world oil supply is linked to

1. Reserves: Depletion of proven oil reserves – the faster that demand grows, the quicker the expected rate of depletion
2. Exploration: Investment spending on exploring, identifying and then exploiting new oil reserves. When oil prices are rising and are expected to stay strong for the foreseeable future, it makes financial sense to invest more resources in exploring for new reserves, even though these may not come on stream for some years.
3. Technology: Technological change in oil extraction (which affects the costs of extraction and the profitability of extracting and then refining the oil)

The interaction between oil demand and supply in the short run

Higher oil demand matched against an inelastic short run supply of oil invariably drives market prices higher – this is shown in the diagram below. An increase in demand causes a fall in oil stocks at the major international refineries and pushes prices higher. This acts as a signal to suppliers to expand production. However there are time lags between a change in price and extra supplies coming on stream.

The demand for oil is also price inelastic. This combination of an inelastic demand and supply helps to explain some of the volatility in world oil prices.

The role and impact of the OPEC cartel

The Organization of Petroleum Exporting Countries (OPEC) accounts for around 40% of current world supply. This gives OPEC a pivotal influence in shaping the direction of oil prices – but only when the cartel acts together to control production and balance supply and demand in the international market. Non-OPEC countries account for the largest portion of total supply. Oil is produced in nearly every corner of the world, and nearly every region has been expanding oil production in the last decade. This includes Europe, where Norwegian oil companies are achieving a rapid increase in oil extraction and also Russia now one of the world’s largest oil suppliers.

OPEC sets quotas for how much crude oil they want to produce with the aim of stabilising the price at a target level. There are always major doubts about OPEC’s ability to keep to output limits. Basically, OPEC acts as the swing producer in the world oil market. It controls that part of the world supply curve which is easiest to change and if it wants to keep oil prices high, then it can keep tight control on short run production so that supply does not run too far ahead of demand. OPEC has to tread a fine line, because if prices remain too high for a long period, then oil consumers have a clear incentive to look for alternative sources of energy or other non-oil substitutes in production.

The microeconomic consequences of higher oil prices

Crude oil has many uses in many different markets and industries. So changes in the global price of oil inevitably have an effect on the microeconomics of particular sectors of the economy. The main uses for crude oil are as follows:

1. Gasoline: motor spirit/petrol
2. Middle Distillates:
1. Diesel - vehicles and other motors/engines
2. Jet fuel
3. Kerosene – cooking/heating
4. Heating Oil
5. Fuel Oil: boiler fuel for industry, power and shipping
6. Other: lubricants, bitumen etc

The economic effects of high oil prices

After a long period of relatively low oil prices, in the last few years, the world economy has had to come to terms with the prospect that the era of cheap oil is now over. This affects many industries in the UK economy and has direct and indirect effects on consumers.

For those industries that use oil as a key input into their production process, then a rising price acts as a supply-side shock – leading to higher input costs i.e. a rise in their variable costs of production. The more an industry relies on oil, the bigger will be the impact of a rise in oil prices on its costs and profitability, and hence the bigger the fall in its production is likely to be in the long run.

The increase in costs causes a profit maximising firm to increase price and reduce the equilibrium level of output. The extent to which a business is able to pass on an increase in costs depends on the price elasticity of demand for their products. If demand is price inelastic, then the supplier may choose to pass on some or all of any rise in variable costs to the consumer of the final product. For example, a controversial issue has been the decision by many (although not all) of the airlines to increase their fuel surcharges to customers.

For consumers, higher oil prices has led directly to more expensive fuel at the pumps, higher gas and electricity bills and a reduction in their real incomes.

Although oil and gas prices have been very high, so far we have not seen a dramatic rise in inflation – other factors have helped to keep inflation under control.