Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin Chapter 38 Energy Prices

1- 2 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 38-2 Chapter Outline Historical View OPEC Why Prices Change So Fast? What Will The Future Hold? Kick It Up A Notch

1- 3 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 38-3 Real Oil and Gas Prices 2005 dollars Per gallon (1 barrel=42 gallons)

1- 4 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 38-4 Historical Events Relating to Oil and Gas Prices 1972 Arab-Israeli War US support for Israel prompted an embargo by Arab oil producers against the US and Europe. This led to a significant increase in crude oil prices Iranian Revolution Iran’s Islamic revolution led to instability in the Persian Gulf. This led to a significant increase in crude oil prices. 1980’s Rapid increases in profits led to significant discoveries of oil in Mexico and the North Sea Iran-Iraq War The war led to increased production by both parties as each needed to fund their war effort. This caused a precipitous fall in crude oil prices.

1- 5 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 38-5 World Oil Reserves GroupBillions of Barrels in ReservePercentage of World Reserves Persian Gulf74760% Non-Persian Gulf OPEC 18115% Rest of the World31025%

1- 6 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 38-6 OPEC The Organization of Petroleum Exporting Countries (OPEC) Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, and Venezuela OPEC began as a cartel. A cartel is an organization of individual competitors that join to form as a single monopolist.

1- 7 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 38-7 Was OPEC a Cartel? OPEC production has always been a significant part of the oil market but it has never reached the level of monopoly. The cartel model is still useful because it has been a dominant player.

1- 8 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 38-8 The Cartel Model One Country’s Oil MC ATC P Q MR P cartel MR’ Q cartel P Q D S=MC Market for Oil Q PC P PC MR Q PC Q quota Profit Q cheat Profit

1- 9 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 38-9 Why Oil and Gas Prices Change So Fast Because expected price is a determinant of supply and demand a world event that causes people to expect a price increase will Increase current demand (as middlemen and consumers try to buy as much as possible) Decrease current supply (as middlemen and gas stations try to hold onto their current stocks) This causes an immediate increase in prices.

1- 10 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin Historical Events Relating to Oil and Gas Prices 1990 Iraq Invasion of Kuwait OPEC massive overproduction 1999OPEC discipline 2003US invasion of Iraq Hurricanes in the Gulf of Mexico 2007Iran-US tensions; Commodity Speculation 2008Global Financial Crisis

1- 11 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin From $1 to $4 in Ten Years 1)OPEC production cuts; Low stocks of oil; bad weather 2)Release of oil from the Strategic Petroleum Reserve; recession 3)Political unrest in oil producing Venezuela and Nigeria; War in Iraq 4)Hurricanes Damage Platforms in the Gulf of Mexico 5)Threatened Conflict b/w U.S. Iran 6)Global Commodity Speculation 7)Global Financial Crisis

1- 12 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin Gasoline Prices

1- 13 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin Gasoline Prices and Hurricanes A significant portion of refining capacity in the US is in the Gulf of Mexico

1- 14 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin Electricity Residential electric power tends to be sold by a regulated monopoly. It has been a monopoly because of significant barriers to entry. It has been regulated because prices would be much higher than is socially optimal.

1- 15 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin Types of Monopolies Simple Monopoly: a monopoly in which marginal costs of production are rising. Natural Monopoly: a monopoly in which marginal costs of production are falling.

1- 16 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin Monopoly in the Market for Residential Electricity The market for residential electricity is likely to be a natural monopoly for nuclear power because of the very high fixed costs (transmission lines and the power plant and diminishing marginal costs.) The market may be characterized as a simple monopoly or natural monopoly for coal or gas generated electricity.

1- 17 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin An Unregulated Simple Monopoly P Q MC Monopoly D MR Q monopoly P monopoly

1- 18 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin An Unregulated Natural Monopoly P Q MC Monopoly D MR Q monopoly P monopoly ATC

1- 19 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin An Regulated Simple Monopoly P Q MC Monopoly D MR Q monopoly P monopoly P regulated Q regulated

1- 20 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin An Regulated Natural Monopoly P Q MC Monopoly D MR Q monopoly P monopoly ATCP regulated Q regulated