Here's a handy chart of oil prices since 1860 (from here). The long run price of a barrel of oil seems to be about $20, with occasional spikes over $100, like the one we're in at the moment.:
What peculiar property does the market for oil have which makes it exhibit these spikes? I don't think there were any sudden increases in consumption (or falls in production), as the following chart (from here) shows:
The most likely explanation is that both the supply of and demand for oil are not very price sensitive (i.e. price inelastic). Once you've got your oil well and up and running, the best thing to do is to keep pumping nice and steady, you can't quickly increase output and you can't just turn them off either. Similarly, oil is essential for the economy, people need to drive to work, supermarkets have to have their food delivered by lorry, ships have to carry cargo across the oceans etc etc. What makes the demand for oil even less price sensitive is that it is only a small part of people's budgets (the value of crude oil used is only about two per cent of UK's GDP, or less than five per cent if you add duty and VAT on top).
So a supply-demand chart looks like this:
Now, let's assume there's a small fall in the quantity supplied at any price (Venezuelan oil wells not being maintained properly, North Sea starting to dry up, Iran partial embargo) so the supply curve shifts left; and there's a small increase in quantity demanded at any price (from speculators, a recovering economy), then the new equilibrium quantity is unchanged, but there will be a huge increase in the price:
Bonus rounds. What happens to the quantity of oil extracted if they slap a huge great annual tax on ownership of the natural resources? Answer, nothing, because their revenue maximising output level is unchanged.
What happens to the quantity of oil consumed if they slap a huge great tax on pump prices? Answer, not much because quantity demanded is fairly insensitive to price.
The only really bad taxes on the oil industry are taxes on the incomes of those people actually doing stuff, risking millions for prospecting, investing billions in offshore drilling rigs, risking life and limb to keep it all working, running a petrol station etc. But the chances are that these taxes are passed on to the owners of the natural resources and the consumers respectively.
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17 comments:
Mark
Will we ever see $50-60 dollars a barrel in the medium to long term again, and why isn't any price drop in oil reflected at the pumps for any length of time...and I'm not just talking about price wars between retailers.
There must be times when oil companies buy at very competitive prices...but who gains from this? Certainly not the consumer.
I remember when it was 50p a gallon! back in 1972 or thereabouts.
Re the oil price chart. There's a complication - the 'value' of the USD has fallen over that time period - inflation. The 'money of the day' line shows this. If I could find it again, somewhere on the web there is a very good chart plotting the gold price against the oil price. The plots are very similar - especially since the USD was taken off the gold standard in 1971. I'll go and look soem more...
JJ, whether or not we'll see $20 a barrel again (as last seen in the late 1990s), your guess is as good as mine.
Remember: crude oil prices work out at about 40p per litre (USD 110 divided by 1.6 to convert to GBP, divided by 159 to convert to litres) and there's 60p duty on top and then 20% VAT on top of that.
So if oil went down to $20 a barrel, a litre of crude oil would cost about 8p, stick on 5p for refining and transport, retailer's margin, 60p duty and VAT and the pump price would be about 88p per litre. which was the typical price paid back in 2006 and 2007.
Forget about 50p a gallon, real prices are more interesting, if you index that up for average earnings, it's £8.70, divided by 4.54 to convert gallon price to litre price = £1.91.
L, we can completely ignore the nominal price, it's only the price in today's money which matters.
Found this:
http://www.gold-eagle.com/editorials_00/wanniski061900.html
..and this
http://spilpunt.blogspot.com/2008/01/gold-price-vs-oil-price-60-years_13.html
...and this
http://www.incrediblecharts.com/economy/gold_oil_ratio.php
and this:
http://www.gold-eagle.com/editorials_05/hommelberg081805.html
Broadly the consensus is that the gold/oil price ratio is about 16:1.
I know that this isn't what you were on about - i.e. supply and demand elasticty - but I thought'd it'd be interesting as currently the decline in money values, aka inflation, is distorting all sort of economic actions and decisions.
L, that's very relevant and illustrates the same point.
We can safely assume that the supply of gold is even less price elastic than the price of oil, because most gold which will ever be mined already has been, and new gold coming out of the ground is nigh irrelevant. The quantity is fixed (like land).
Therefore it only take a small shift in the demand curve (to the right) because people are worried about inflation to send the price soaring, then the bubble becomes self sustaining.
I think that all natural resources exhibit similar price spikes, be in wheat or copper or anything.
You're ignoring time-scale. On a long enough time-scale, the increased price of oil leads to its abandonment as a fuel for electricity generation, for example. Where the inelasticity really comes in is in applications where oil products have no peers - transport fuels and lubricants. Even there, long term there will be a rwesponse.
Derieme - indeed. Capitalism is all about efficiency - all other things being equel. As the 'cost' of oil rises substitutes will be found that 'cost' less. Mind you capitalism also find efficiencies in the use of resources, for example more efficient use of oil in cars (extra mpg).
MW. The problem we have, I think, but I am not sure, is inflation. Inflation as defined by the Austrians that is. There are huge presentational problems in arguing about all this based on the 'rise' in the price oil, when in fact no such thing has happend. What has happend is the destruction of the value of our money by endemic inflation caused by central banks, retail banks and politicians.
D, no I'm not ignoring it. I have used charts showing what actually happened to prices and volume, and by definition, those charts will incorporate the moves towards a bit more fuel efficiency from the 1970s onwards.
a) It is assumed that in the long run, demand is more price sensitive than in the short term because people choose substitutes or drive smaller cars etc. On the other hand, in the medium term demand might be less price sensitive than in the short term, because people just get used to the higher price.
b) We can also assume that in the long run, supply is more price sensitive than the short term, because more expensive sources of oil come into play (like North Sea).
The two cancel out and so what anyway? The point of the post was merely to illustrate what happens to price and quantity when both supply and demand are price inelastic. Quantity can't change much (by definition) so prices go up and down like crazy.
L, that's why I used a chart showing "real" price of oil, the pale green line. Ignore the dark green line for nominal. Even with complete price stability, we would get spikes in oil prices, apart from perhaps stoking a bit of speculation, these price spikes are entirely independent of monetary inflation.
MW - Agreed. You have ueed the 'real' price and so do I. But, everyone else screams when the oil 'price' rises to $100 or whatever, when in 'real' terms it's no more costly that in was 5 years ago or whatever. In other words we may a reasoned debate about all this, but it does not suit the powers that be to do so.
Mark, we can sum up a lot of what you have said quite simply: when supply (of anything) is basically tight, extreme volatility - as well as high price - is a very usual concomitant
(if we get anywhere near the fabled 'peak oil' - whatever that means - volatility will get even worse)
You are restricting your discussion to short-range marginal economics of the physical commodity (concentrating on spot price) and ignoring a couple of other massive factors
(1) politics (esp OPEC but also see last year's massive release of IEA reserves), which sometimes leads to non-economic (or at least 'strategic') decision-making: 'nuff said
(2) the forward market. Very few economists (or govt decision-makers) have a clue how the forward market actually works beyond a very low-level theoretical understanding: but it can impact significantly on the spot (physical) market, and is often the means that big players use to manipulate the market
there is another factor (which can relate to (2))
(3) the (apparent) irrationality of even the non-political oil producers. Example: sometimes they keep producing when they ought to 'shut in' and sell forward
(I say 'apparent' because there can be several complicating factors in play: but I have been close enough to some actual decisions to know that irrationality is often real enough)
ND, you know far more than me about about the specific workings and peculiar economics of the oil and gas sectors than I do, and all your oil-related points stand, but your statement...
"when supply (of anything) is basically tight, extreme volatility - as well as high price - is a very usual concomitant"
Is wrong as that's only half the story. The point of the post is that you need to have price insensitive demand as well to generate price spikes.
The supply of anything is tight in the short term and is subject to sudden supply outages. Let's say that a container ship from the Far East bound for Europe bearing six months supply of TV sets were to sink and no new TVs were to arrive on our shores for six months, would the price of TV's spike from £200 to £1,000 each?
No of course not, because demand for TVs is price sensitive, and people would rather make do with their existing ones than to pay £1,000 for a new one which will only cost £200 once new supply comes back on line.
But with oil we don't have that luxury of saying "OK, we'll leave our cars in the garage for six months until the price comes down again" so we grit our teeth and pay the higher prices.
I accept the general point; but there is a question of degree
in the UK, total demand for natural gas is quite sensitive to day-to-day pricing, because 40% is used in power generation, a good chunk of which can and does still switch very swiftly to coal if the price dictates
(of course, residential demand is completely insensitive to spot- price because no home-owner pays spot price)
when gas supply is generally tight, a spot shortage will see prices spike (dramatically) and volatility increase - even though there is a pretty prompt and often significant demand response (don't have data in front of me but I'd say there can sometimes be a good 10% reduction in total gas demand)
maybe a 10% response still counts as insensitive for these purposes!
ND I wasn't using gas as an example, the mechanics of that are much more complicated.
I was using oil/petrol as an example, where the link between crude prices, taxes and pump prices [can be assumed to be] much more direct.
"a good chunk of which can and does still switch very swiftly to coal if the price dictates"
Out of interest, how swiftly - hours, days, weeks, months?
"maybe a 10% response still counts as insensitive for these purposes"
It certainly counts as insensitive if that's the response to the price doubling or trebling!
between hours & days, depending on the fuel mix at the time
and accordingly the price spikes don't last long before mean reversion kicks in
You have changed your blog description-- Noticed
ND, thanks, I didn't know that. Obviously, this won't apply once the EU have forced us to shut down our coal plants; clearly the EU are doing this entirely out of concern for the environment and not because they have an interest in selling us [Russian] gas...
D, ta.
ND, agreed - politics. Immensely important. Basically, the US never wants to be vulnerable to an emargo and price shock like the 70s again, so it tolerates the cartel OPEC keeping prices high enough so that marginal producing areas explore and open wells ensuring diversity of supply - Texas, Canada, Mexico etc. But the bargain is that OPEC keeps the US in the price decision loop and doesn't normally let the price go too high, which would cause inflation and enrich a volatile region near Israel. The bargain changed in the last few years because the US was scared of deflation, and is scared of the Arab Spring leading to unmaleable democracies. (16 out of 18 twin tower bombers were frustrated Saudis. Democracy would be far harder to deal with than the geriatric house of Saud)
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