The Central Problem of Economics (Oil)

Economics may seem like a topic that can be so closely related to what’s happening in the economy but to really express it seems like an entirely different matter. Economics is the study of how society allocates limited resources to the production of goods and services to satisfy unlimited human wants.

There are two types of economics: macroeconomics and microeconomics. Macroeconomics deals with economy-wide phenomena such as changes in unemployment, national income, rate of growth, gross domestic product (GDP), inflation and price levels. Microeconomics on the other hand, deals with analysing the market behaviour of individual consumers and firms in an attempt to understand the decision making process of firms and households. Microeconomics focuses on the individual aspects of the economy, while macroeconomics looks at the big picture of the economy.

In this series of economics application, let us try to understand the different types of resources and what scarcity is before diving into how it can be applied to one compelling topic going on in the global economy these days.

Factors/Types of Production

Of course, in order to produce goods and services, an economy needs to have resources. The more the amount of resources an economy has, the more the amount of goods and services it can produce. Resources are usually divided into 4 categories also known as 4 factors of production: land, labour, capital and enterprise.

Resources

Land refers to gifts of nature that are used to produce goods and services.

Labour refers to the physical and mental effort that people devote to the production of goods and services.

Capital refers to the goods that are produced for use in the production of other goods. It includes factories and machinery.

Enterprise refers to the ability and willingness to take risk.

Scarcity, Choice and Opportunity Cost

We know that human always have unlimited wants but there are only so much resources on earth that can be utilized to fulfil our needs. The more resources we use to satisfy our needs, the lesser there is left to fulfil other wants. This would in turn, give rise to scarcity as limited resources becomes insufficient to produce goods and services to satisfy unlimited human wants. Scarcity then requires us to make choices, to choose what goods and services to produce. When a choice is made, an opportunity cost is incurred because the same amount of resources that can be used to produce good B is now used to produce good A. The opportunity cost of a course of action is the benefit forgone by not choosing its next best alternative. In other words, when the society chooses what goods and services to produce, it is also choosing what goods and services not to produce.

Economic Efficiency

Due to the problem of scarcity, all economies must make three fundamental economic decisions:

  1. What and how much to produce
  2. How to produce
  3. For whom to produce

In making these three fundamental economic decisions, the objective is to maximize the welfare of the society. However, there occur times where this may not be the case.

Fear of Oil Scarcity

During 2003, the price for oil rose above $30, reached $60 by Aug 2005 and peaked at $147.30 in Jul 2008. Commentators attributed that this was caused by a number of factors such as tension in Middle East, soaring demand in China, the falling value of U.S. currency, a decline in petroleum reserves, worries over peak oil and last but not least, financial speculation. In 2008, despite vast investment in exploration and production of oil, international oil companies fail to replace the oil they produce each year with fresh discoveries, or even to maintain current levels of output. Shell’s oil production has been falling for six years, BP’s oil production seem to have peaked in 2005 while Exxon admitted that its output has fallen by 10% in the first quarter of 2008. Evidence shows that the world is soon reaching “peak oil” because oil companies have been setting record high oil prices and absurd rising fuel costs. It was no surprise that the persistent increase in oil prices over the past decade suggests that global oil market have entered a period of increased scarcity. Oil has become a limited resource because it becomes insufficient to fulfil every country’s needs and wants.

The Economics of Oil Change Begins

Over the past five years, prices of oil have hovered around $110/barrel and this has caused oil men from North Dakota and Texas to complete almost 20,000 new wells since 2010. It is not surprising because everyone wants a share of the large pie of profits oil can provide. However, what they did not foresee was what follow suit after. Oil prices began falling into a vicious downward spiral as major economies started slowing, demand for oil stagnate, increased U.S. domestic crude oil and OPEC’s decision to maintain current export levels. In 2014, this combination has caused excess oil supply to lead a 50% market decline. (Read more on: Will Oil Prices Recover in 2015?)

Just last month, despite plummeting oil prices and growing disagreements among members of the OPEC, OPEC have decided to continue increasing oil production levels, to a rate not seen in 30 years. Doug Terreson, an oil analyst with Evercorer ISI, explained that demand will rise between 1.3 and 1.5 million barrels per day (bpd) in 2016 and non-OPEC supply, specifically U.S. shale, will decline around 400,000 (bpd) for which OPEC will compensate this by increasing 500,000 (bpd), causing inventory to eventually decline on a whole. However, this is not to mention that despite the pressure placed on high cost crude producers, like the U.S. shale frackers, they have proven to be unexpectedly resilient. Even if there may be a significant reduction in the number of oil rigs left in the U.S. fields, it seems that production of oil in America has only decreased slightly. The outcome that Saudi Arabia wishes to see by agreeing to cut its production by up to 1 million (bpd) only if non-OPEC members like Russia, Mexico, Oman and Kazakhstan agrees to reduce output, seems to be a little questionable after all.

An Eager Iran to Re-Enter the Oil Exports After International Sanctions Lift

With Iran’s return to the international oil market after years of international sanctions, it is unlikely that they would agree especially when Iranian leaders have said that they plan to bring 500,000 (bpd) of oil to markets as soon as possible. The world is already oversupplied with approximately 1.5 million barrels of oil. The pain that Saudi Arabia is causing to its other OPEC members is real; not all OPEC members share similar low costs in digging oil out from the ground, and it will not be before long that one of them could not hold out anymore. On Jan 18, 2016, oil prices dives below $29 a barrel for the first time since 2003. While cheaper oil may offer an excellent economic boost as fuel now cost cheaper than ever before, it is in fact causing chaos in the energy sector. Profits skydived, jobs slashed and dozens of oil companies have already filed for bankruptcy. In fact, markets could drown in an oversupply of oil.

As mentioned earlier, in order to produce goods and services, an economy needs to have resources. The more the amount of resources an economy has, the more the amount of goods and services it can produce. Human wants are always unlimited and scarcity of resources requires us to make choices but what if there is too much resources to the extent the economy is becoming imbalance?

We’ll talk about more in our next Economics topic.

References

Daugherty, D. 2015. “Analyst: Oil Supply and Demand to Rebalance in 2016.” Rigzone.

DiChristopher, T. 2015. “Kilduff: Why Saudi Arabia won’t cut output.” CNBC.

Egan, M. 2016. “Oil prices dive on Iran sanctions fallout.” CNN Money.

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

Quek, E. 2015. “The Central Problem of Economics.” Economics Café.

Strahan, D. 2008. “Oil is expensive because it is scarce.” The Telegraph.

Wencl, E. 2015. “Oil prices dive below $29 a Barrel.” Kvrr.

Wikipedia. 2003. “2000s energy crisis.”

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