Oil at $300 Barrel: is this realistic – Thushara Amaranayaka, May 2011

Oil 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 within

next five years, due to current Middle East crisis and the surge in demand. Below is an excerpt from

a 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 the

price elasticity of oil.

A "Model" of Chaos

The Middle Eastern and North African (MENA) countries produced 22.7 million barrels per day in

2010, rather more than U.S. consumption.

However, two of those countries can be left out of the equation. Iran already is run by radicals - any

change there would be an upgrade. And Iraq is a democracy that's host to 50,000 U.S. troops; one

must 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 won't even matter if these countries refuse to export to the West: If their

oil goes to China, India or elsewhere, it will simply be a substitute for - and therefore free up - oil that

had been coming from other regions.

Now I will concede that a wholesale change to economically inept regimes in the Middle East will

lead to reduced output. For instance, when the Shah Mohammad Reza Pahlavi was ousted in the

Iranian 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 that

succumb to radicalism. If all of them except Iran and Iraq went radical, that would reduce global

energy output by 9.9 million barrels per day - or 11.4% of last year's total world output.

It used to be very difficult to figure out how much price effect a supply shortfall might have, but

fortunately we now have a "control experiment" to use as a model. I'm talking, of course, about the

record-oil-price spike of 2007-08.

A Calculated Impact

Between the summer of 2007 and its successor in 2008, oil prices rose by 70% while U.S. consumption

fell by 4% (when the year's modest economic growth is corrected for).

That means the "price elasticity of demand" - an economic term that measures the responsiveness

of buyers to a change in price - is about 4/70. Plug that figure back into the supply shortage of

11.4% and you get a price increase of about 200% (Output Reduction of 11.4% x Price Elasticity of

70/4 = Price Change of 200%).

In other words, were we to have a "worst-case scenario" revolution in the Middle East, we would

be looking at the current price of oil (about $100 per barrel) increasing by 200% - to about $300 a

barrel (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 would

see less of a drop in demand than we would; emerging-market economies, on the other hand, are

much poorer, and might well see an even-bigger drop-off in demand, perhaps even returning to

bicycle transportation.

Even so, our $300-a-barrel estimate feels like a good round number that's backed by logic and a

certain economic soundness.

Under such a scenario, we'd be looking at U.S. gas prices of about $9.57 a gallon - up from the

current $3.19. The cost to the typical motorist - who uses about 500 gallons of gas - would be an

additional $2,700 (assuming that his usage declined by 11.4%).

(Hutchinson, 2011)

Is this realistic?

Analysis of the control experiment

Summary of calculations for the control experiment: Using a supply drop of 11.5% and US demand

drop of 4 % and price rise of 70% during 2007-2008 period

Plugging in above numbers to the formula,

Elasticity = 70/4

% Change in Price= Price Elasticity X %Change in Quantity

200 = 70/4 * 11.5

US Demand US Price Elasticity

-4% 70% 70/4

Supply Drop Elasticity Price Increase

11.5% 70/4 $ 201

The Control experiment ignores the supply and demand dynamics due to price changes; these

factors radically change the oil price. The model extrapolates demand for oil at $300/barrel using its

current price elasticity of demand. Oil is relatively price inelastic, overall demand for oil will not

decrease that much with price rises.

Analyst uses the current price elasticity of demand to estimate a future price ,based on Middle East

supply disruption and panic. One of the problems with this methodology is that the price inelasticity

of demand would likely radically shift for oil once it hits a certain level. I.e. At current prices there

are no substitutes for oil, at $250 or $300 alternative technologies and substitutes will have more

value and consumer demand will shift down.

Also the analysis ignores the fact that oil would become much more price elastic at higher price

levels. What’s more is in the short term supply would also increase at higher price levels.

Due to above factors it’s highly unlikely that oil will reach $300 within five years.

Lesson 1: Oil price is highly sensitive to supply dynamics

The 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 let’s see what happens to price.

Plugging above changes the numbers in to above equation, 0.1=%Change in Price/0.01

Price Elasticity %Change in Demand %Change in Price

0.1 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.

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 for

2008-2010 show, even with real price rises; oil consumption has risen and predicted to rise.

Source: Short-Term Energy Outlook, March 2011

Lesson 3: Is Long term Oil price elastic on inelastic

In the long run demand for oil and price should be relatively elastic. At higher prices consumers will

look for substitutes. During recent oil price surge and GFC there has been drop in some consumer

demand 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 a

contradiction to the intuition above.

This is mainly due to

High economic growths around the world and people are willing to pay more because of the

economic growth.

If real incomes remained constant, higher prices would reduce the demand, but generally

real incomes rise.

Also reduced demand in some parts of the world is offset but economic and income growth.

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Source: BP Statistical Review of World Energy June 2010

Source: BP Statistical Review of World Energy June 2010

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Works Cited Administration, U. E. (2011). Short-Term Energy Outlook. Washington, DC 20585: U.S. Energy

Information Administration.

Hutchinson, M. (2011). This Middle East Meltdown Will Send Oil to $300 a Barrel – and Pump Prices

to $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.