The effects of changes in the price of crude oil traded on the international petroleum exchanges can be far-reaching, not just for the British economy but for the global economy too. A basic study of the oil market is a useful application of the principles of supply and demand analysis and a way of understanding the interconnections between the microeconomics of the oil market and their macroeconomic consequences.
Market theory in action - what determines crude oil prices?
Oil is one of the most heavily traded commodities in the world. Fluctuating prices have important effects for oil producers/exporters and the many countries that remain dependent on oil as a key input in their energy, manufacturing and service industries.
The demand for oil
- Cyclical demand: There is a strong link between the demand for oil and the rate of global economic growth because oil is an essential input into many industries – when the economy is expanding, the demand for oil rises. The best recent example of this is the growth of the Chinese economy. Fast growth of national output in energy-intensive sectors has led to a surge in demand for crude oil into the Chinese economy.
- Prices of substitutes: Demand for crude oil affected by the relative prices of oil substitutes (e.g. the market price of gas). If, in the longer term, reliable and relatively cheaper substitutes for oil can be developed, then we might expect to see a shift in demand away from crude oil towards the emerging substitutes. The high price of oil during 2004-2006 seems to have led to a rise in research and development into non-oil substitutes. These can take several years to come through to affect the market for energy.
- Changes in climate – e.g. affecting the demand for heating oil. It is often said that if the winter in North America is fierce, then the price of crude rises as the USA and Canadian economies raise their demand for oil to fuel household heating systems and workplaces
- Market speculation: There is always a speculative demand for oil (i.e. purchasers hoping for a rise in prices on world markets). Indeed one of the features of the most recent spike in oil prices has been the high level of demand by hedge funds and other investors pouring into the international petroleum exchanges to buy up any surplus oil futures contracts. They hope that by the time the contracts are ready to be fulfilled, they will have made a large profit. Speculation involves risk, prices can do down as well as up.
Who are the main consumers of oil? Nearly two thirds of global crude oil production is consumed by the leading industrialised nations – i.e. the nations that make up the Organisation of Economic Cooperation and Development. But a rising share of oil demand is coming from the emerging market economies including China, Brazil, Russia and India.
The world's largest consumers of oil
Consumption of oil in 2005 Thousand barrels daily
Share of total consumption %
The supply of oil
When we consider the global supply of oil we need to make a distinction between short-term and longer-term supply to the international markets. The short run supply curve is normally drawn on the basis of a given state of production technology and fixed use of capital inputs (i.e. the oil industry is supplying from a known level of oil reserves and a given stock of capital machinery used to extract that oil). There is inevitably a short-run limit on daily oil supply and, as production gets close to capacity limits, so the short run supply of oil becomes more inelastic.
One possible way of modelling this is to assume the market supply curve for oil is non-linear (shown in the left hand diagram below). An alternative is to suggest that more oil can be supplied elastically at a fairly constant price until the capacity limit is reached, when the short run supply curve becomes vertical.
In short, the short-run supply of crude oil is affected by a series of different factors
- Profit motive: The production decisions of OPEC and Non-OPEC countries (see revision notes on OPEC below)
- Spare capacity: The level of spare production capacity in the oil sector
- Stocks: The current level of crude oil stocks (inventories) available for immediate supply from the major oil refineries – i.e. a high level of stocks means that extra oil supplies can be released onto the market quickly when demand fluctuates
- External shocks: The effects of production shocks (e.g. loss of output from rig closures or disruption of oil supplies due to war and terrorist attacks)
Taking a longer-term perspective, the long run world oil supply is linked to
- Reserves: Depletion of proven oil reserves – the faster that demand grows, the quicker the expected rate of depletion
- Exploration: Investment spending on exploring, identifying and then exploiting new oil reserves. When oil prices are rising and are expected to stay strong for the foreseeable future, it makes financial sense to invest more resources in exploring for new reserves, even though these may not come on stream for some years.
- Technology: Technological change in oil extraction (which affects the costs of extraction and the profitability of extracting and then refining the oil)
The interaction between oil demand and supply in the short run
Higher oil demand matched against an inelastic short run supply of oil invariably drives market prices higher – this is shown in the diagram below. An increase in demand causes a fall in oil stocks at the major international refineries and pushes prices higher. This acts as a signal to suppliers to expand production. However there are time lags between a change in price and extra supplies coming on stream.
The demand for oil is also price inelastic. This combination of an inelastic demand and supply helps to explain some of the volatility in world oil prices.
The role and impact of the OPEC cartel
The Organization of Petroleum Exporting Countries (OPEC) accounts for around 40% of current world supply. This gives OPEC a pivotal influence in shaping the direction of oil prices – but only when the cartel acts together to control production and balance supply and demand in the international market. Non-OPEC countries account for the largest portion of total supply. Oil is produced in nearly every corner of the world, and nearly every region has been expanding oil production in the last decade. This includes Europe, where Norwegian oil companies are achieving a rapid increase in oil extraction and also Russia now one of the world’s largest oil suppliers.
World Oil Production
Production on oil
Output as a share
Thousand barrels daily
of world total
United Arab Emirates
Total production 000 barrels daily
Output as a percentage of total world output
Total World Oil Production in 2005
Of which OPEC countries
Former Soviet Union
OPEC sets quotas for how much crude oil they want to produce with the aim of stabilising the price at a target level. There are always major doubts about OPEC’s ability to keep to output limits. Basically, OPEC acts as the swing producer in the world oil market. It controls that part of the world supply curve which is easiest to change and if it wants to keep oil prices high, then it can keep tight control on short run production so that supply does not run too far ahead of demand. OPEC has to tread a fine line, because if prices remain too high for a long period, then oil consumers have a clear incentive to look for alternative sources of energy or other non-oil substitutes in production.
The microeconomic consequences of higher oil prices
Crude oil has many uses in many different markets and industries. So changes in the global price of oil inevitably have an effect on the microeconomics of particular sectors of the economy. The main uses for crude oil are as follows:
- Gasoline: motor spirit/petrol
- Diesel - vehicles and other motors/engines
- Kerosene – cooking/heating
- Fuel Oil: boiler fuel for industry, power and shipping
- Other: lubricants, bitumen etc
The economic effects of high oil prices
After a long period of relatively low oil prices, in the last few years, the world economy has had to come to terms with the prospect that the era of cheap oil is now over. This affects many industries in the UK economy and has direct and indirect effects on consumers.
For those industries that use oil as a key input into their production process, then a rising price acts as a supply-side shock – leading to higher input costs i.e. a rise in their variable costs of production. The more an industry relies on oil, the bigger will be the impact of a rise in oil prices on its costs and profitability, and hence the bigger the fall in its production is likely to be in the long run.
The increase in costs causes a profit maximising firm to increase price and reduce the equilibrium level of output. The extent to which a business is able to pass on an increase in costs depends on the price elasticity of demand for their products. If demand is price inelastic, then the supplier may choose to pass on some or all of any rise in variable costs to the consumer of the final product. For example, a controversial issue has been the decision by many (although not all) of the airlines to increase their fuel surcharges to customers.
For consumers, higher oil prices has led directly to more expensive fuel at the pumps, higher gas and electricity bills and a reduction in their real incomes.
Although oil and gas prices have been very high, so far we have not seen a dramatic rise in inflation – other factors have helped to keep inflation under control
Today, the environmental impact of products and processes plays a major role in long-term sustainability of companies and their appreciation on the stock market. Investing in fuel technology has been a key factor in the development of environmentally correct vehicles (less polluting) and has promoted technological progress for producing top quality clean fuels. Vehicle technology, in response to the environmental challenge, has presented prototypes for optimizing fuel consumption, using modern combustion techniques and electronic management (hybrids and fuel cells). It is expected that from 2020 there will be not just one predominant fuel, and this may change oil company strategies and further integrate the automobile industry.
Economies of scale arise when the cost per unit falls as output increases. Economies of scale are the main advantage of increasing the scale of production and becoming ‘big’.
Why are economies of scale important?
- Firstly, because a large business can pass on lower costs to customers through lower prices and increase its share of a market. This poses a threat to smaller businesses that can be “undercut” by the competition
- Secondly, a business could choose to maintain its current price for its product and accept higher profit margins. For example, a furniture-maker which could produce 1,000 cabinets at £250 each might expand and be able to produce 2,000 cabinets at £200 each. The total production cost will have risen to £400,000 from £250,000, but the cost per unit has fallen from £250 to £200. Assuming the business sells the cabinets for £350 each, the profit margin per cabinet rises from £100 to £150.
There are two main types of economies of scale: internal and external. Internal economies of scale have a greater potential impact on the costs and profitability of a business.
Internal economies of scale
Internal economies of scale relate to the lower unit costs a single firm can obtain by growing in size itself. There are five main types of internal economies of scale.
As businesses grow they need to order larger quantities of production inputs. For example, they will order more raw materials. As the order value increases, a business obtains more bargaining power with suppliers. It may be able to obtain discounts and lower prices for the raw materials.
Businesses with large-scale production can use more advanced machinery (or use existing machinery more efficiently). This may include using mass production techniques, which are a more efficient form of production. A larger firm can also afford to invest more in research and development.
Many small businesses find it hard to obtain finance and when they do obtain it, the cost of the finance is often quite high. This is because small businesses are perceived as being riskier than larger businesses that have developed a good track record. Larger firms therefore find it easier to find potential lenders and to raise money at lower interest rates.
Every part of marketing has a cost – particularly promotional methods such as advertising and running a sales force. Many of these marketing costs are fixed costs and so as a business gets larger, it is able to spread the cost of marketing over a wider range of products and sales – cutting the average marketing cost per unit.
As a firm grows, there is greater potential for managers to specialise in particular tasks (e.g. marketing, human resource management, finance). Specialist managers are likely to be more efficient as they possess a high level of expertise, experience and qualifications compared to one person in a smaller firm trying to perform all of these roles.
External economies of scale
External economies of scale occur when a firm benefits from lower unit costs as a result of the whole industry growing in size. The main types are:
Transport and communication links improve
As an industry establishes itself and grows in a particular region, it is likely that the government will provide better transport and communication links to improve accessibility to the region. This will lower transport costs for firms in the area as journey times are reduced and also attract more potential customers. For example, an area of Scotland known as Silicon Glen has attracted many high-tech firms and as a result improved air and road links have been built in the region.
Training and education becomes more focused on the industry
Universities and colleges will offer more courses suitable for a career in the industry which has become dominant in a region or nationally. For example, there are many more IT courses at being offered at colleges as the whole IT industry in the UK has developed recently. This means firms can benefit from having a larger pool of appropriately skilled workers to recruit from.
Other industries grow to support this industry
A network of suppliers or support industries may grow in size and/or locate close to the main industry. This means a firm has a greater chance of finding a high quality yet affordable supplier close to their site.
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