doc 3 demand and supply for oil (2)

8/3/2019 Doc 3 Demand and Supply for Oil (2)

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ECON 1112 M.Pourhosseini

ADJUSTING TO OIL PRICESHOCKS

GROUP 7AVINASHBHUPESH

PRAMITSASMITATANYA


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Facts about OPEC

OPEC was founded in 1960 to unify and protecttheinterests of oil-producing countries.It control the price of oil.OPEC has 11 member countries, including foundermembers Iran, Iraq, Kuwait and Venezuela.Two-thirds of the oil reserves in the world belong

to OPECmembersOPEC responsible for half of the world's oil exports


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Oil price changes

Between December1973 and June1974, the

Organization ofPetroleum Exporting

Countries (OPEC) putup the price of oilfrom $3 to $12 perbarrel. It wasfurther raised toover $30 in 1979.

In the late 1980sthe pricefluctuated, but the

trend wasdownward. Exceptfor a sharp rise atthe time of the Gulf

War in 1990, thetrend continued inthe early 1990s.
http://www.opec.org/home/http://www.opec.org/home/


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Reduction of oil price in 1990s

By 1996, the price was fluctuating around$16 per barrel: in real terms (i.e. aftercorrecting for inflation), roughly the level

prior to 1973. The situation for OPEC deteriorated further

in the late 1990s, following the recession inthe Far East. Oil demand fell by some 2million barrels per day.

By early 1999, the price had fallen toaround $10 per barrel a mere $2.70 in1973 prices!


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Reducing supply

In response, OPEC members agreedto cut production by 4.3 millionbarrels per day.

The objective was to push the priceback up to around $18$20 perbarrel.


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Economic growth anddemand for oil

But, with the Asian economyrecovering and the world generallyexperiencing more rapid economic

growth, the price rose rapidly,reaching over $35 in late 2000.

The effect was to trigger protestsaround the world, with pressure ongovernments to cut fuel taxes.


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Increased demand from China

Pressure on the oil price eased over the nextcouple of years and in 2001 the price fell backto $24 per barrel.

However, the war in Iraq, rapid growth indemand from China and concerns about world

oil production pushed it strongly upwards from2003 onwards, with the price reaching $80 perbarrel in August 2006.


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price movements

The price movements can be explainedusing simple demand and supply analysis

Diagram (a) shows the effects of OPECs

actions: the price rises from P1 to P2. Toprevent a surplus at that price, OPECmembers restricted their output by agreedamounts. This had the affect of shifting the

supply curve to S2, with Q2 beingproduced.
http://tonto.eia.doe.gov/dnav/pet/hist/rbrteM.htmhttp://tonto.eia.doe.gov/dnav/pet/hist/rbrteM.htmhttp://tonto.eia.doe.gov/dnav/pet/hist/rbrteM.htmhttp://tonto.eia.doe.gov/dnav/pet/hist/rbrteM.htm


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The initial rise in price

P

QO

D1 (short-run)

Q1

P1

S2

P2

Q2

S1

A

B

Diagram (a) An initial restriction of supply


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The initial rise in price

This reduction in output needed to be onlyrelatively small because the short-rundemand for oil was highly price-inelastic:

for most uses there are no substitutes inthe short run.


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Adjustments

With high oil prices persisting, peopletried to find ways of cutting back onconsumption. People bought smaller

cars. They converted to gas or solidfuel central heating. Firms switchedto other fuels. Less use was made ofoil-fired power stations for electricity

generation. Energy saving schemesbecame widespread both in firms andin the home


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Long-run effects on demand

P

QO

D1

S2

P2

S1

B

A

D2

P3

DL

C

Diagram (b) Long-run demand response

The long rundemand for oilis more elastic


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long-run demand curve of DL

This had the effect of shifting theshort-run demand curve from D1 toD2 in diagram b. Price fell back fromP2 to P3. This gave a long-rundemand curve of DL: the curve thatjoins points A and C.

The fall in demand was madebigger by a world recession in theearly 1980s.


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Long-run effects on supply

With oil production so much moreprofitable, there was an incentive for nonOPEC oil producers to produce oil.

Prospecting went on all over the world andlarge oil fields were discovered and openedup in the North Sea, Alaska, Mexico, Chinaand elsewhere.

In addition, OPEC members weretempted to break their "quotas" (theirallotted output) and sell more oil.


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increase in world oil supplies.

The net effect was an increase in world oilsupplies. In terms of the diagrams, thesupply curve of oil started to shift to theright from the mid-1980s onwards, causingoil prices to fall through most of the periodup to 1998. This is shown by a shift in thesupply curve to S3 in Diagram (c).


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Long-run effects on supply

P3

P

QO

D1

S2

P2

S1

P1

B

A

C

D2

S3

D

Diagram (c) Long-run supply response


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short-run supply curves

Equilibrium price thus fell back to P1(point D). Note that the supply curvesin these diagrams are all short-runsupply curves, since each one showssupply for a particular number of oilfields.


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Constructing a long run supply curve

P3

P

QO

D1

S2

P2

S1

P1

B

A

C

D2

S3

D

Diagram (d) Constructing a long-run supply curve

SL

E

F


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long-run supply curve

The reasoning is as follows. After thelimiting of supply to S2, OPEC memberswould have supplied at point E, had the

price remained at P1. After some yearswith the price set at P2 or thereabouts,more suppliers enter the market. Thesupply curve shifts to S3. Had the demand

curve not shifted, equilibrium would thenhave moved to point F: the intersection ofS3 and the original demand. A long-runsupply curve thus links points E and F.


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Back to square one and worse

By the late 1990s, with the oil price as lowas $10 per barrel, OPEC once more cutback supply. The story had come full circle.This cut-back is illustrated in diagram (a).

The trouble this time was that worldwideeconomic growth was picking up. Demandwas shifting to the right. The result was arise in oil prices to around $33, which then

fell back again in 2001 as the world slippedinto recession and the demand curveshifted to the left.


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Leftward shift

There were then some large pricesincreases, first as a result of OPEC in late2001 attempting once more to restrictsupply (a leftward shift in supply),

then, before the Iraq war of 2003, becauseof worries about possible adverse effects onoil supplies (a rightward shift in demand ascountries stocked up on oil).
http://tonto.eia.doe.gov/dnav/pet/hist/rbrteM.htmhttp://tonto.eia.doe.gov/dnav/pet/hist/rbrteM.htmhttp://tonto.eia.doe.gov/dnav/pet/hist/rbrteM.htmhttp://tonto.eia.doe.gov/dnav/pet/hist/rbrteM.htm


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problems with supply

In 2004 OPEC relaxed its quotas totry to prevent the price rising further,but problems with supply limited howmuch it could shift the supply curveto the right to ease the price.


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rapid economic growth of China

Worries about insecurity of supply,combined with the rapid economicgrowth of China, continued to shiftthe demand curve to the right and, asstated at the beginning of this casestudy, by August 2006, oil prices had

risen to around $80 per barrel.
http://www.guardian.co.uk/oil/story/0,,1840152,00.htmlhttp://www.guardian.co.uk/oil/story/0,,1840152,00.html


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swings in times of shortage oroversupply

We have seen that crude oil pricesbehave much as any othercommodity with wide price swings intimes of shortage or oversupply.

The crude oil price cycle may extendover several years responding to

changes in demand as well as OPECand non-OPEC supply.


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Oil is a normal good

We have seen in this lecture that theprice of oil follows the normal forcesof demand and supply.

doc 3 demand and supply for oil (2)

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