What is Really Behind The Oil Drop?

Drilling rigs being reassigned due to drop in oil prices

In our previous article on The Demand and Supply Imbalance, we learnt that a fall in price will lead to an increase in quantity demanded and vice versa. We learnt that despite oil prices falling to 13-year lows, demand was unable to increase by the same proportion, thus continuing to drown the world in an oversupply as an equilibrium could not be achieved.

In this series of economics application, I will be relating how price elasticity of demand is connected to the result of low oil prices.

 

The price elasticity of demand (PED) for a good is a measure of the degree of responsiveness of the quantity demanded to a change in price, ceteris paribus. It is calculated by dividing the percentage change in the quantity demanded by the percentage change in the price.

PED = % ∆ Quantity Demanded_

                        % ∆ Price

If PED > 1, demand is price elastic

That is to say that a change in price will lead to larger percentage change in quantity demanded. A good with a price elastic demand has a gradual sloping demand curve. For example, if the price of Topone bread increases, consumers will switch to alternatives as there are so many better alternatives out there.

If PED < 1, demand is price inelastic

Which means that a change in price will lead to a smaller percentage change in the quantity demanded. A good with a price inelastic demand has a relatively steep demand curve. For example, even if the price of iPhones were to increase, many would continue to pay a premium for their products.

If PED = 1, demand is unit price elastic

Which means to say that a change in price will lead to the same percentage change in the quantity demanded.

Do you now know why when the price of oil decreases, demand did not increase by the same proportion? Simply because, the demand of oil is not unit price elastic. Question is, is the demand of oil price elastic or inelastic?

 

The concept of PED allows a firm to determine how to change price to increase total revenue.

Say, if the demand of good A is price elastic, the firm can decrease the price to increase its total revenue as the quantity demanded will increase by a larger percentage.

If the demand for good B is price inelastic, then the firm can increase the price to increase its total revenue as quantity demanded will decrease by only a smaller percentage.

If the demand for good C is unit price elastic, then the firm will not change its price as the quantity demanded will change by the same percentage as well.

Since the price of oil has been falling since 2014 while the quantity demanded did not increase by a larger percentage, it is likely that the demand of oil is not price elastic as well. As European economies and developing countries are weak and vehicles have become more energy efficient (Krauss 2016), the demand of oil despite a lower price were unable to increase by a larger proportion. It is hence safe to say that the demand of oil is therefore, price inelastic.

The following determinants of price elasticity of demand can prove that.

Determinants of Price Elasticity of Demand
Determinants of Price Elasticity of Demand

The main alternatives for oil include nuclear energy, solar energy, oil sands, wind power, hybrid cars, and shale formation natural gas, just to name a few. However, these alternatives are not closely related to oil. Even energy conglomerates like Exxon has failed in finding enough new oil and gas to replace what it produced last year. In fact, it replaced only two-thirds of its 2015 oil and gas output, joining other energy conglomerates such as Royal Dutch Shell PLC and BP PLC in failing to replace 100% of its reserves. Despite the rising prices of oil since 2003 until its peak at $147.30 in July 2008, the quantity demanded for oil did not decrease by a large proportion and in fact, oil was so highly demanded that firms kept increasing its price to increase total revenue. There is no denying that we need oil to a large extent. Besides, given any price increase in oil, quantity demanded will not fall in the short run as people still need to drive their cars. This is especially when it does not require them to spend a large proportion of their income on oil. The price hike was still something consumers can generally afford.

Now that we know the demand for oil is price inelastic, what about the supply of oil?

 

The price elasticity of supply (PES) is a measure of the degree of responsiveness of the quantity supplied to a change in the price, ceteris paribus. The PES of a good is calculated by dividing the percentage change in the quantity supplied by the percentage change in price.

PES = % ∆ Quantity Supplied

               % ∆ Price

Due to the law of supply, the PES of a good is always positive.

If PES > 1, supply is price elastic

This means that a change in price will lead to a larger proportionate change in quantity supplied. A good with a price elastic supply has a relatively flat supply curve.

If PES < 1, supply is price inelastic

Which means that a change in price will lead to a smaller proportionate change in the quantity supplied. A good with a price inelastic supply has a relatively steep supply curve.

If PES = 0, the supply is unit price elastic

Which means that a change in price will lead to the same percentage change in the quantity supplied.

 

Consider the effect of a fall in oil prices. While it may hurt producers in the short run, any rational producer will continue producing to ensure that their costs is spread over the larger quantity of oil they produce. Oil producers with higher cost of production will be forced to shut eventually. Production is likely to continue until any income earned is less than the marginal cost of production. That is why an increase in U.S. domestic crude oil and OPEC’s decision to maintain current export levels has caused excess oil supply to lead to a 50% market decline (Miller 2014). Since a larger percentage of oil is produced when there is a change in the price of oil, it is likely that the supply of oil is price elastic.

The following determinants of price elasticity of supply can prove that.

Determinants of Price Elasticity of Supply
Determinants of Price Elasticity of Supply

At the rate that OPEC members are producing oil, it seems that once new oil wells have been found and are already invested in, it does not require much production time nor does it cost much for oil to be drilled out of the ground. Besides, its non-perishable nature and large capacity of oil allows the supply of oil to be price elastic as well.

So now that we know that the demand of oil is price inelastic whereas the supply of oil is price elastic, what are the effects of elasticity on price and quantity?

When demand decreases, price and quantity will fall. If supply is price elastic, the increase in price is likely to be small and the increase in quantity is likely to be large. However, if supply is to increase as with the case of oil, an inelastic demand curve is likely to cause the increase in price to be large and the decrease in quantity to be small. That is why oil prices began free falling into a vicious downward spiral as demand from major economies started slowing and stagnating while U.S. domestic crude oil and OPEC decided to maintain current export levels. The effect on price will ultimately depend on the relative changes in demand and supply.

Will Oil Prices Recover Again?

The demand supply imbalance of oil that has tilted in a way that it seems almost impossible for oil prices to recover in the short run. The global oil market has been substantially oversupplied, and should demand not be able to catch up, the world will continue to swim in some 1-2 million barrels of oil every day, even more so if Iran refuses to back down.

The good old days of high oil prices may indeed be over. Last week, international benchmark Brent crude rose comfortably above $42 a barrel as the US Energy Information Administration showed US oil output had dipped closer to nine million barrels a day – and could fall to 8.6 million by the end of this year and 8.2 million by the end of 2017. However, according to several analysts, many U.S. independent oil producers and scores of smaller ones need only $40-$60 to breakeven and that is why supply could be coming back on line. This may drive the de facto leader of OPEC to push prices back down, as it can break even with prices as much lower as $20 a barrel.

With an inelastic demand for oil that has yet to catch up and an elastic supply of oil waiting to overflow, the global oil market could be drowning more so than ever before.

References

Krauss, C. 2016. “Oil Prices: What’s Behind the Drop? Simple Economics.” The New York Times.

Miller, J. 2014. “Are declining oil prices increasing the risks to OPEC, U.S. Energy Security or Clean fuels supplies?” The Energy Collective.

Mourdoukoutas, P. 2016. “Saudi Arabia Won’t Let Oil Prices Stay Over $40.” Forbes.

Olson, B. 2016. “Exxon fails to replace oil, gas production for the first time in 22 years.” Wallstreet Journal.

Texas, Y. 2016. “Oil below $30 fans wipeout fears among U.S. shale survival artists.” Reuters.

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