ECON 1112 M.Pourhosseini MSc in Financial Management and Investment Analysis University of Greenwich...

ECON 1112 M.Pourhosseini

MSc in Financial Management and Investment Analysis

University of Greenwich Business school


Economics 1112

Economics for Finance and Investment Analysis


Dr M. Pourhosseini Case study seminar on 6th October 2008

Doc.3 –

Demand and Supply for oil


Supply and demand In Doc 1 and Doc 2 we discuss Supply and

demand in a free-market economy where prices play a key role in transmitting information from buyers to sellers and from sellers to buyers.

We discussed what determines demand and supply and changes in price affect the quantity demanded and supplied.


Background

We also considered two main approaches to analysing consumer behaviour: the marginal utility approach and the indifference approach.

In this document we look at these forces for a particular commodity : oil


Adjusting to Oil Price Shocks

We look at the developments in the oil market in the last 35 years.

We look at the Short-run and long-run demand and supply curves


Prices before 1973 From 1958 to 1970 prices were stable at

about $3.00 per barrel, but in real terms the price of crude oil declined from above $17 to below $14 per barrel.

The decline in the price of crude when adjusted for inflation was amplified for the international producer in 1971 and 1972 by the weakness of the US dollar.


Shift of power Throughout the post war period exporting countries

found increasing demand for their crude oil but a 40% decline in the purchasing power of a barrel of oil. In March 1971, the balance of power shifted

the power to control crude oil prices shifted from the United States to OPEC.

there was no more spare capacity and therefore no tool to put an upper limit on prices.

A little over two years later OPEC would, through the unintended consequence of war, get a glimpse at the extent of its power to influence prices.


Oil price changes Between December

1973 and June 1974, the Organization of Petroleum Exporting

Countries (OPEC) put up the price of oil from $3 to $12 per barrel. It was further raised to over $30 in 1979.

In the late 1980s the price fluctuated, but the trend was downward. Except for a sharp rise at the time of the Gulf War in 1990, the trend continued in the early 1990s.


Reduction of oil price in 1990’s

By 1996, the price was fluctuating around $16 per barrel: in real terms (i.e. after correcting for inflation), roughly the level prior to 1973.

The situation for OPEC deteriorated further in the late 1990s, following the recession in the Far East. Oil demand fell by some 2 million barrels per day.

By early 1999, the price had fallen to around $10 per barrel – a mere $2.70 in 1973 prices!


Reducing supply

In response, OPEC members agreed to cut production by 4.3 million barrels per day.

The objective was to push the price back up to around $18–$20 per barrel.


Economic growth anddemand for oil

But, with the Asian economy recovering and the world generally experiencing more rapid economic growth, the price rose rapidly, reaching over $35 in late 2000.

The effect was to trigger protests around the world, with pressure on governments to cut fuel taxes.


Increased demand from China Pressure on the oil price eased over the next

couple of years and in 2001 the price fell back to $24 per barrel.

However, the war in Iraq, rapid growth in demand from China and concerns about world oil production pushed it strongly upwards from 2003 onwards, with the price reaching $80 per barrel in August 2006.

By August 2008 the price reached £140 per barrel


price movements The price movements can be explained

using simple demand and supply analysis Diagram (a) shows the effects of OPEC’s

actions: the price rises from P1 to P2. To prevent a surplus at that price, OPEC members restricted their output by agreed amounts. This had the affect of shifting the supply curve to S2, with Q2 being produced.


The initial rise in price

P

Q O

D1 (short-run)

Q1

P1

S2

P2

Q2

S1

A

B

Diagram (a) An initial restriction of supply


The initial rise in price

This reduction in output needed to be only relatively small because the short-run demand for oil was highly price-inelastic: for most uses there are no substitutes in the short run.


Long-run effects on demand

The long-run demand for oil was more elastic. This is shown in Diagram (b).


Adjustments With high oil prices persisting, people

tried to find ways of cutting back on consumption. People bought smaller cars. They converted to gas or solid fuel central heating. Firms switched to other fuels. Less use was made of oil-fired power stations for electricity generation. Energy saving schemes became widespread both in firms and in the home


Long-run effects on demand

P

Q O

D1

S2

P2

S1

B

A

D2

P3

DL

C

Diagram (b) Long-run demand response


long-run demand curve of DL

This had the effect of shifting the short-run demand curve from D1 to D2 in diagram b. Price fell back from P2 to P3. This gave a long-run demand curve of DL: the curve that joins points A and C.

The fall in demand was made bigger by a world recession in the early 1980s.


Long-run effects on supply

With oil production so much more profitable, there was an incentive for non OPEC oil producers to produce oil. Prospecting went on all over the world and large oil fields were discovered and opened up in the North Sea, Alaska, Mexico, China and elsewhere.

In addition, OPEC members were tempted to break their "quotas" (their allotted output) and sell more oil.


increase in world oil supplies. The net effect was an increase in world oil

supplies. In terms of the diagrams, the supply curve of oil started to shift to the right from the mid-1980s onwards, causing oil prices to fall through most of the period up to 1998. This is shown by a shift in the supply curve to S3 in Diagram (c).


Long-run effects on supply


short-run supply curves

Equilibrium price thus fell back to P1 (point D). Note that the supply curves in these diagrams are all short-run supply curves, since each one shows supply for a particular number of oil fields.


long-run supply curve

Drawing a long-run supply curve is more difficult: it depends when in the story we start and what assumptions we make. We could draw a long-run supply curve linking points E and F in Diagram (d ).


Constructing a long –run supply curve


long-run supply curve The reasoning is as follows. After the limiting

of supply to S2, OPEC members would have supplied at point E, had the price remained at P1. After some years with the price set at P2 or thereabouts, more suppliers enter the market. The supply curve shifts to S3. Had the demand curve not shifted, equilibrium would then have moved to point F: the intersection of S3 and the original demand. A long-run supply curve thus links points E and F.


Back to square one – and worse By the late 1990s, with the oil price as low

as $10 per barrel, OPEC once more cut back supply. The story had come full circle. This cut-back is illustrated in diagram (a).

The trouble this time was that worldwide economic growth was picking up. Demand was shifting to the right. The result was a rise in oil prices to around $33, which then fell back again in 2001 as the world slipped into recession and the demand curve shifted to the left.


Russian oil

Russian production increases dominated non-OPEC production growth from 2000 forward and was responsible for most of the non-OPEC increase since the turn of the century.


Leftward shift There were then some large

prices increases, first as a result of OPEC in late 2001 attempting once more to restrict supply (a leftward shift in supply),

then, before the Iraq war of 2003, because of worries about possible adverse effects on oil supplies (a rightward shift in demand as countries stocked up on oil).


problems with supply

In 2004 OPEC relaxed its quotas to try to prevent the price rising further, but problems with supply limited how much it could shift the supply curve to the right to ease the price.


rapid economic growth of China

Worries about insecurity of supply, combined with the rapid economic growth of China, continued to shift the demand curve to the right and, as stated at the beginning of this case study, by August 2006, oil prices had risen to around $80 per barrel.


GLOBAL OIL PRODUCTION FORECAST: 1950 to 2050

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© Energyfiles Ltd

DISCOVERIES

PRODUCTION


swings in times of shortage or oversupply

We have seen that crude oil prices behave much as any other commodity with wide price swings in times of shortage or oversupply.

The crude oil price cycle may extend over several years responding to changes in demand as well as OPEC and non-OPEC supply.


Current world supply


OPEC Crude oil supply


Current word demand


Oil is a normal good

We have seen in this lecture that the price of oil follows the normal forces of demand and supply.

ECON 1112 M.Pourhosseini MSc in Financial Management and Investment Analysis University of Greenwich...

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Transcript of ECON 1112 M.Pourhosseini MSc in Financial Management and Investment Analysis University of Greenwich...