1. ECON 1112 M.Pourhosseini MSc in Financial Management and Investment Analysis University of Greenwich Business school

2. ECON 1112 M.Pourhosseini Economics 1112 Economics for Finance and Investment Analysis

3. ECON 1112 M.Pourhosseini Dr M. Pourhosseini Case study seminar on 6 th October 2008 Doc.3 – Demand and Supply for oil

4. ECON 1112 M.Pourhosseini Supply and demand  In Doc 1 and Doc 2 we discuss Supply and demand in a free-market economy where prices play a key role in transmitting information from buyers to sellers and from sellers to buyers.  We discussed what determines demand and supply and changes in price affect the quantity demanded and supplied.

5. ECON 1112 M.Pourhosseini Background  We also considered two main approaches to analysing consumer behaviour: the marginal utility approach and the indifference approach.  In this document we look at these forces for a particular commodity : oil

6. ECON 1112 M.Pourhosseini Adjusting to Oil Price Shocks  We look at the developments in the oil market in the last 35 years.  We look at the Short-run and long-run demand and supply curves

7. ECON 1112 M.Pourhosseini Prices before 1973  From 1958 to 1970 prices were stable at about $3.00 per barrel, but in real terms the price of crude oil declined from above $17 to below $14 per barrel.  The decline in the price of crude when adjusted for inflation was amplified for the international producer in 1971 and 1972 by the weakness of the US dollar.

8. ECON 1112 M.Pourhosseini Shift of power  Throughout the post war period exporting countries found increasing demand for their crude oil but a 40% decline in the purchasing power of a barrel of oil. In March 1971, the balance of power shifted  the power to control crude oil prices shifted from the United States to OPEC.  there was no more spare capacity and therefore no tool to put an upper limit on prices.  A little over two years later OPEC would, through the unintended consequence of war, get a glimpse at the extent of its power to influence prices.

9. ECON 1112 M.Pourhosseini Oil price changes  Between December 1973 and June 1974, the Organization of Petroleum Exporting Countries (OPEC) put up the price of oil from $3 to $12 per barrel. It was further raised to over $30 in 1979.OPEC  In the late 1980s the price fluctuated, but the trend was downward. Except for a sharp rise at the time of the Gulf War in 1990, the trend continued in the early 1990s.

10. ECON 1112 M.Pourhosseini Reduction of oil price in 1990’s  By 1996, the price was fluctuating around $16 per barrel: in real terms (i.e. after correcting for inflation), roughly the level prior to 1973.  The situation for OPEC deteriorated further in the late 1990s, following the recession in the Far East. Oil demand fell by some 2 million barrels per day.  By early 1999, the price had fallen to around $10 per barrel – a mere $2.70 in 1973 prices!

11. ECON 1112 M.Pourhosseini Reducing supply  In response, OPEC members agreed to cut production by 4.3 million barrels per day.  The objective was to push the price back up to around $18–$20 per barrel.

12. ECON 1112 M.Pourhosseini Economic growth and demand for oil  But, with the Asian economy recovering and the world generally experiencing more rapid economic growth, the price rose rapidly, reaching over $35 in late 2000.  The effect was to trigger protests around the world, with pressure on governments to cut fuel taxes.

13. ECON 1112 M.Pourhosseini Increased demand from China  Pressure on the oil price eased over the next couple of years and in 2001 the price fell back to $24 per barrel.  However, the war in Iraq, rapid growth in demand from China and concerns about world oil production pushed it strongly upwards from 2003 onwards, with the price reaching $80 per barrel in August 2006.  By August 2008 the price reached £140 per barrel

14. ECON 1112 M.Pourhosseini price movements  The price movements can be explained using simple demand and supply analysisprice movements  Diagram (a) shows the effects of OPEC’s actions: the price rises from P1 to P2. To prevent a surplus at that price, OPEC members restricted their output by agreed amounts. This had the affect of shifting the supply curve to S2, with Q2 being produced.

15. ECON 1112 M.Pourhosseini The initial rise in price

16. ECON 1112 M.Pourhosseini The initial rise in price  This reduction in output needed to be only relatively small because the short-run demand for oil was highly price-inelastic: for most uses there are no substitutes in the short run.

17. ECON 1112 M.Pourhosseini Long-run effects on demand  The long-run demand for oil was more elastic. This is shown in Diagram (b).

18. ECON 1112 M.Pourhosseini Adjustments  With high oil prices persisting, people tried to find ways of cutting back on consumption. People bought smaller cars. They converted to gas or solid fuel central heating. Firms switched to other fuels. Less use was made of oil-fired power stations for electricity generation. Energy saving schemes became widespread both in firms and in the home

19. ECON 1112 M.Pourhosseini Long-run effects on demand

20. ECON 1112 M.Pourhosseini long-run demand curve of DL  This had the effect of shifting the short-run demand curve from D1 to D2 in diagram b. Price fell back from P2 to P3. This gave a long-run demand curve of DL: the curve that joins points A and C.  The fall in demand was made bigger by a world recession in the early 1980s.

21. ECON 1112 M.Pourhosseini Long-run effects on supply  With oil production so much more profitable, there was an incentive for non OPEC oil producers to produce oil. Prospecting went on all over the world and large oil fields were discovered and opened up in the North Sea, Alaska, Mexico, China and elsewhere.  In addition, OPEC members were tempted to break their "quotas" (their allotted output) and sell more oil.

22. ECON 1112 M.Pourhosseini increase in world oil supplies.  The net effect was an increase in world oil supplies. In terms of the diagrams, the supply curve of oil started to shift to the right from the mid-1980s onwards, causing oil prices to fall through most of the period up to 1998. This is shown by a shift in the supply curve to S3 in Diagram (c).

23. ECON 1112 M.Pourhosseini Long-run effects on supply

24. ECON 1112 M.Pourhosseini short-run supply curves  Equilibrium price thus fell back to P1 (point D). Note that the supply curves in these diagrams are all short-run supply curves, since each one shows supply for a particular number of oil fields.

25. ECON 1112 M.Pourhosseini long-run supply curve  Drawing a long-run supply curve is more difficult: it depends when in the story we start and what assumptions we make. We could draw a long-run supply curve linking points E and F in Diagram (d ).

26. ECON 1112 M.Pourhosseini Constructing a long –run supply curve

27. ECON 1112 M.Pourhosseini long-run supply curve  The reasoning is as follows. After the limiting of supply to S2, OPEC members would have supplied at point E, had the price remained at P1. After some years with the price set at P2 or thereabouts, more suppliers enter the market. The supply curve shifts to S3. Had the demand curve not shifted, equilibrium would then have moved to point F: the intersection of S3 and the original demand. A long-run supply curve thus links points E and F.

28. ECON 1112 M.Pourhosseini Back to square one – and worse  By the late 1990s, with the oil price as low as $10 per barrel, OPEC once more cut back supply. The story had come full circle. This cut-back is illustrated in diagram (a).  The trouble this time was that worldwide economic growth was picking up. Demand was shifting to the right. The result was a rise in oil prices to around $33, which then fell back again in 2001 as the world slipped into recession and the demand curve shifted to the left.

29. ECON 1112 M.Pourhosseini Russian oil  Russian production increases dominated non-OPEC production growth from 2000 forward and was responsible for most of the non-OPEC increase since the turn of the century.

30. ECON 1112 M.Pourhosseini Leftward shift  There were then some large prices increases, first as a result of OPEC in late 2001 attempting once more to restrict supply (a leftward shift in supply),prices increases  then, before the Iraq war of 2003, because of worries about possible adverse effects on oil supplies (a rightward shift in demand as countries stocked up on oil).

31. ECON 1112 M.Pourhosseini problems with supply  In 2004 OPEC relaxed its quotas to try to prevent the price rising further, but problems with supply limited how much it could shift the supply curve to the right to ease the price.

32. ECON 1112 M.Pourhosseini rapid economic growth of China  Worries about insecurity of supply, combined with the rapid economic growth of China, continued to shift the demand curve to the right and, as stated at the beginning of this case study, by August 2006, oil prices had risen to around $80 per barrel.around $80 per barrel.

33. ECON 1112 M.Pourhosseini

34. swings in times of shortage or oversupply  We have seen that crude oil prices behave much as any other commodity with wide price swings in times of shortage or oversupply.  The crude oil price cycle may extend over several years responding to changes in demand as well as OPEC and non-OPEC supply.

35. ECON 1112 M.Pourhosseini

36. Current world supply

37. ECON 1112 M.Pourhosseini OPEC Crude oil supply

38. ECON 1112 M.Pourhosseini Current word demand

39. ECON 1112 M.Pourhosseini Oil is a normal good We have seen in this lecture that the price of oil follows the normal forces of demand and supply.