The Oil Price – micro-Economics 101

So why has the oil price plunged so low, when it was so high only a few months ago?

Isn’t this very strange behaviour?

Answer: no.

Did you do basic economics? Ever?

What we are seeing is a phenomenon called Elasticity.

The thing is, supply and demand for oil are both relatively inelastic, that is, they change slowly. I still need to drive my car the same distance to work every day whether fuel is £1.10 a litre or £1.50. If fuel prices are high, I’ll be more likely to choose a more economical car when I buy a new one in a few years’ time; if they’re low, I might put speed or luxury above fuel economy.  But that’s for a few years down the line: now,  I still need to put forty litres of fuel in my tank once every couple of weeks, whatever the price.

It takes years (and billions of dollars) to bring new oil production on-stream. A low oil price today means that production projects due to come on stream in five or ten years’ time might get shelved now – not least because oil companies don’t have the surplus cash flow to finance the exploration and development; but the expensive wells drilled last year are still producing even if they’ll never cover the cost of drilling. You’d lose even more money by turning the taps off because the price is too low.

If the total world supply of oil is just a little bit below the total world demand, the price will rocket. Everyone needs that last barrel of oil. Conversely, if the supply is just a little bit over what’s needed, you can’t give the stuff away. Well, once all the storage tanks are full.

What’s happening now is that  production that was approved based on a $150 oil price is coming on-stream.  And people are driving the 70mpg cars they bought last year.

This phenomenon isn’t limited to oil; it’s most problematic with agricultural produce, which is why the EU has intervention pricing, which attempts to buy up stock when prices are low and sell them on to the market when prices are high. But even that didn’t really work, since if intervention prices are too high the inevitable landscape of butter mountains and wine lakes develops, and there was always political pressure from producers to keep the intervention prices high. Oil is such a huge global commodity that intervention would require spectacular amounts of money.  Saudi Arabia has huge oil reserves and flexible production – its wells are relatively shallow and mostly onshore, so they can be turned on and off at relatively low cost. It could, almost, be a swing producer; but it would mean ceding market share to the Russians and Americans and helping its sworn enemy on the other side of the Gulf.

So – volatile oil prices are nothing new. As we become a less energy-intensive economy globally, oil demand is likely to become unlinked from economic growth (the process is already happening), and therefore even more inelastic.  We may be in for five years of relatively low oil prices, and as high-cost, short-lived wells, including in particular US shale goes off-stream, the situation will flip and supply will fall below demand, we’ll see the $250 barrell, and the process will start again.

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