Monday, May 23, 2011

Economics of Oil Prices

Yesterday afternoon, I spent a few minutes explaining the movement of oil prices to a friend of mine. Lots of gestures and real-world analogies later, I think I did a sufficient job at describing the pattern of oil prices movement. I thought it would be worthwhile to explain to all you (imaginary?) readers too.

First off, when I say "oil prices", I am not talking about the price of a barrel of oil at the commodities exchanges worldwide. That would make this blog post too obtuse -- not to mention a bit beyond my knowledge. The term "oil prices" henceforth will only refer to the prices each of us see at the gas station placards. For the past month or so, this price has been steadily increasing above the $4 price mark.

Now let's delve into the economics of explaining the movement of oil prices. To do so, we will need the standard set of economic tools: the classic supply and demand curves. [The following explanation will be a bit cumbersome as I am not able to readily draw the curves myself -- thus I need to "borrow" from other sites. Hopefully my explanations make enough sense.]

We start with the equilibrium price and quantity of oil. The demand curve is reflects the market demand curve, or the desire for oil by everyone in the economy. This ranges from individuals to airline companies, trucking companies, etc. -- the bottom line is that everyone aggregately pays the same price. On the other side are the oil suppliers. Because there are many different suppliers (e.g. Arab countries, North Sea, Alaska), they also aggregately form a supply curve.
As the graph suggests, the slopes of the demand and supply curves are characterized as negative and positive respectively. This makes intuitive sense according to the overarching economic rule of scarcity, which states that the rarer a resource, the more expensive it is. For instance, a rare good like a diamond is expensive largely because it is rare and deemed valuable. The cardinal rule of scarcity is reflected in the demand curve: when an individual only has a small amount of a good, then the price paid (in economic speak, willingness to pay) is high but this prices decreases as we move further along the demand curve. There ultimately reaches a point where an individual no longer wants a good, even when the price is zero (e.g. eating the sixth Big-Max in a row).

The inverse is true for supply -- with the key difference being that suppliers are more reactive to the market price. For instance, when the sale price is low (on the left side of the graph), few suppliers would consider it worthwhile to produce and thus there is a small quantity available. But as the sale/market prices increases, more and more firms enter the market in attempts to profit. Therefore the slope of the supply curve is positive: as the price goes up, the more goods are available on the market.

The intersection point of supply and demand curve is called the equilibrium price and quantity. Here, both "demanders" (or consumers) and suppliers reach a point where both sides are satisfied. The result is zero waste. [In economic jargon, this is where the notion of efficiency kicks in. The equilibrium point is considered Pareto Efficient.]

However, there often are changes (or shocks) to either the demand curve, the supply curve, or both simultaneously. And this is where we return to our subject of oil prices. The price of oil is inherently a supplier-driven economy, as the supply available ultimately determines if we can drive our cars, or fly our airplanes. In other words, suppliers have more control. The price of oil has increased recently due to a contraction in the supply curve (Example II below).

Recent events like the attacks on Libya and other oil-producing countries likely hampered the amount of oil that can be readily brought to the market. The quantity of oil available is reduced (from Q0 to Q1). This leads to the shifting of the supply curve to the left (aka a contraction) which, as the graph shows, results in a higher equilibrium price for the oil (P0 to P1). Gas station owners understandably do not want to bear the burden of the price increase alone, and thereby raise the gas prices charged. In all, this is why we see the higher prices at the pump.

Oil prices fall when either or both of two events happen: (1) the supply curve shifts back out as supply is restored or increased; and (2) the demand also contracts (shifts left). The latter leads to a decrease in price because the point of intersection has now become less than P1 on the previous graph. Oil prices this past week has been falling slightly -- and I believe this to be the reason.

However, the above is only a general description of oil price changes as resulted from economics. In reality, there are many more factors and things can get very complex. One example is the disproportionate effect of commodity traders who trade oil futures (e.g. what it costs you to acquire oil in 6 months time). Sometimes oil prices change not because of major supply shifts, but because of the traders speculating/betting on higher future prices. Oil prices can also go up when demand shifts outward -- a common illustration is China's growing appetite for oil.

[Disclaimer: I realized toward the end that a better term to use in place of "oil prices" could have been "gas prices". Most people understand that "gas" refers to oil, or petroleum. But I am not comfortable with this description...]

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