Oil at $300 Barrel: is this realistic -Analysis of Oil Price and Elasticity

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Transcript of Oil at $300 Barrel: is this realistic -Analysis of Oil Price and Elasticity

  • 1. Oil at $300 Barrel: is this realistic Thushara Amaranayaka, May 2011Oil being one of the most difficult commodities to price, there is plenty of speculation on the price,when there are potential supply shortages.Recently there have been many analyst reports speculating the price for a barrel will top S300 withinnext five years, due to current Middle East crisis and the surge in demand. Below is an excerpt froma recent analyst report, predicting oil price will hit $300 barrel.This is followed by an analysis of model used for predicting oil price and few lessons learnt on theprice elasticity of oil.A "Model" of ChaosThe Middle Eastern and North African (MENA) countries produced 22.7 million barrels per day in2010, rather more than U.S. consumption.However, two of those countries can be left out of the equation. Iran already is run by radicals - anychange there would be an upgrade. And Iraq is a democracy thats host to 50,000 U.S. troops; onemust hope that a regional collapse would pass it by.Realistically speaking, even if run by radicals, Middle Eastern countries will not stop exporting oil;they need the money. And it wont even matter if these countries refuse to export to the West: If theiroil goes to China, India or elsewhere, it will simply be a substitute for - and therefore free up - oil thathad been coming from other regions.Now I will concede that a wholesale change to economically inept regimes in the Middle East willlead to reduced output. For instance, when the Shah Mohammad Reza Pahlavi was ousted in theIranian Revolution of 1979, output fell from 6 million barrels a day to 3 million - a 50% decline.A decline of a similar magnitude seems a reasonable assumption for Middle East countries thatsuccumb to radicalism. If all of them except Iran and Iraq went radical, that would reduce globalenergy output by 9.9 million barrels per day - or 11.4% of last years total world output.It used to be very difficult to figure out how much price effect a supply shortfall might have, butfortunately we now have a "control experiment" to use as a model. Im talking, of course, about therecord-oil-price spike of 2007-08.

2. A Calculated ImpactBetween the summer of 2007 and its successor in 2008, oil prices rose by 70% while U.S. consumptionfell by 4% (when the years modest economic growth is corrected for).That means the "price elasticity of demand" - an economic term that measures the responsivenessof buyers to a change in price - is about 4/70. Plug that figure back into the supply shortage of11.4% and you get a price increase of about 200% (Output Reduction of 11.4% x Price Elasticity of70/4 = Price Change of 200%).In other words, were we to have a "worst-case scenario" revolution in the Middle East, we wouldbe looking at the current price of oil (about $100 per barrel) increasing by 200% - to about $300 abarrel (Current Price of $100/Barrel + 200% Increase = New Price of $300/Barrel).You can quibble with the exact number: Europe has higher gas taxes than the United States, so wouldsee less of a drop in demand than we would; emerging-market economies, on the other hand, aremuch poorer, and might well see an even-bigger drop-off in demand, perhaps even returning tobicycle transportation.Even so, our $300-a-barrel estimate feels like a good round number thats backed by logic and acertain economic soundness.Under such a scenario, wed be looking at U.S. gas prices of about $9.57 a gallon - up from thecurrent $3.19. The cost to the typical motorist - who uses about 500 gallons of gas - would be anadditional $2,700 (assuming that his usage declined by 11.4%).(Hutchinson, 2011)Is this realistic?Analysis of the control experimentSummary of calculations for the control experiment: Using a supply drop of 11.5% and US demanddrop of 4 % and price rise of 70% during 2007-2008 periodPlugging in above numbers to the formula,Elasticity = 70/4% Change in Price= Price Elasticity X %Change in Quantity200 = 70/4 * 11.5US Demand US Price Elasticity-4% 70%70/4Supply Drop Elasticity Price Increase11.5% 70/4 $ 201 3. The Control experiment ignores the supply and demand dynamics due to price changes; thesefactors radically change the oil price. The model extrapolates demand for oil at $300/barrel using itscurrent price elasticity of demand. Oil is relatively price inelastic, overall demand for oil will notdecrease that much with price rises.Analyst uses the current price elasticity of demand to estimate a future price ,based on Middle Eastsupply disruption and panic. One of the problems with this methodology is that the price inelasticityof demand would likely radically shift for oil once it hits a certain level. I.e. At current prices thereare no substitutes for oil, at $250 or $300 alternative technologies and substitutes will have morevalue and consumer demand will shift down.Also the analysis ignores the fact that oil would become much more price elastic at higher pricelevels. Whats more is in the short term supply would also increase at higher price levels.Due to above factors its highly unlikely that oil will reach $300 within five years.Lesson 1: Oil price is highly sensitive to supply dynamicsThe elasticity of oil is very low, maybe as low as 0.1. Let us now evaluate a hypothetical situation,where the supply oil drops by 1%. And lets see what happens to price.Plugging above changes the numbers in to above equation, 0.1=%Change in Price/0.01Price Elasticity%Change in Demand%Change in Price0.1 0.01 10%1 % drop can increase the price by 10%, smallest supply disruptions lead to a huge change in price.Today the oil prices include a high risk premium due to high probability of supply shocks. 4. Lesson 2: Is Short term Oil price elastic on inelastic?Oil is an essential good and in the short term oil price is inelastic. Analyses of short term data for2008-2010 show, even with real price rises; oil consumption has risen and predicted to rise. World Consumption and Oil Price(West Texas Crude)millions of barrels per daydollars per 92barrelWorld oil consumption (left axis)WTI crude oil price (right axis) 115 90 88 95 86 75 84 55 82 80352008-Q1 2009-Q1 2010-Q1 2011-Q12012-Q1Source: Short-Term Energy Outlook, March 2011Lesson 3: Is Long term Oil price elastic on inelasticIn the long run demand for oil and price should be relatively elastic. At higher prices consumers willlook for substitutes. During recent oil price surge and GFC there has been drop in some consumerdemand for oil i.e. using public transport and greener technologies.But analysis of long term data show increasing demand for oil with rising prices. This is acontradiction to the intuition above.This is mainly due to High economic growths around the world and people are willing to pay more because of theeconomic growth. If real incomes remained constant, higher prices would reduce the demand, but generallyreal incomes rise. Also reduced demand in some parts of the world is offset but economic and income growth. 5. Nominal and Real Oil Price 200.00 180.00 160.00 140.00 120.00 100.00Nominal Price80.00Real Price60.0040.0020.00 0.001950190019051910191519201925193019351940194519551960196519701975198019851990199520002005Source: BP Statistical Review of World Energy June 2010Oil Consmption and Real prices 90000 120.00Consumption(Thousand Barrels Per day)Real Price 80000 100.00 70000 60000 80.00 50000 60.00 40000 30000 40.00 20000 20.00 10000 0 0.00Source: BP Statistical Review of World Energy June 2010 6. Works CitedAdministration, U. E. (2011). Short-Term Energy Outlook. Washington, DC 20585: U.S. EnergyInformation Administration.Hutchinson, M. (2011). This Middle East Meltdown Will Send Oil to $300 a Barrel and Pump Pricesto $9.57 a Gallon. Retrieved from Money Morning: http://moneymorning.com/2011/03/02/middle-east-meltdown-will-send-oil-to-300-barrel-pump-prices-to-9-dollars-per-gallon/June, 2. B. (2010). BP Statistical Review of World Energy June 2010. London: BP Global.