Monday, February 7, 2011

Oil Supply and Demand and the Next Oil Price Spike

I gave this presentation to my energy economics class at Cornell last week.  In the presentation I describe how the supply and demand of the world oil industry have changed recently and use this analysis to argue that we will see an oil price spike within the next two years.  Enjoy.

Video Transcript:

"Hi this is Will Martin from and today I’m going to be explaining how the next oil price spike will occur by analyzing the supply and demand of the oil industry.  I gave this presentation to my energy economics class at Cornell last week and I thought it would be good to put it online so that others better understand how the next oil price spike will play out.

This is the traditional economic view of the short-run supply and demand in the oil market.
As supply shifts to the left, for example from a supply disruption like terrorists blowing up a pipeline, the price will increase slightly, and demand will shift to create a new equilibrium.  Likewise, if demand shifted out to the right, perhaps as we moved into the summer driving season, price would increase and supply would shift out to meet it at a new equilibrium.
Many traditional economists believe that the supply and demand curves in the oil market are approximately linear and relatively inelastic with short-run price elasticities of supply and demand at .04 and -.04, respectively.

I, however, respectfully disagree with this traditional view.  When you look at the real world data of world oil production during the last oil price spike in 2008, we see that the actual short-run elasticity of supply was only .0075.
This means that the short-run elasticity of supply is far more inelastic than we would expect.  As oil prices went up significantly in 2008, the market failed to bring significant additional oil production online.
I will argue later in this presentation that in addition to the inelasticity of supply, the short-run demand curve is far more inelastic than most economists believe.

So with demand being more inelastic than expected, the real elephant in the room is the question of OPEC’s spare capacity.  For the last thirty years, OPEC has been one of the few players in the world oil market with the ability to pump more oil at a moment’s notice.  During the last oil price spike, many people questioned this spare capacity, asking, “Is OPEC tapped out?”
Obviously there are a number of reasons for OPEC to lie to the world about their available spare capacity.  Firstly, each OPEC country individually has an economic incentive to overstate their reserves.  In game theory, this is the classic “prisoner’s dilemma” situation.  Each member of the cartel is allowed to produce oil based on the amount of reserves they claim to have.  Since the actual exploration and production data that proves these reserve numbers are state secrets, there are no repercussions for lying about them, since it is impossible for the other cartel members to force you to prove them.  By overstating their reserves, a country is able to make more profit by producing more oil while the cartel keeps the market price high.
In addition to the economic incentive to lie about their oil reserves, OPEC members have huge political incentives to do so as well.  Countries may wish to overstate their oil reserves in order to make themselves seem more important than they really are to international economic and military partners.  Countries like the United States are heavily dependent on foreign oil and are therefore most likely to make economic and military alliances with countries that can supply them oil well into the future.  Many OPEC countries are in unstable areas of the world, surrounded by potentially hostile neighbors, so the incentive to overstate reserves in order to secure these international military partnerships is enormous.
It is also possibly beneficial to overstate reserves in order to quell political turmoil within one’s own country.

But when we look at the data during the last price spike, we see that OPEC’s spare production capacity worked largely as we would have expected it to.  The short-run elasticity of supply of OPEC oil was .048 – on par with what most economists would expect.  This means that, at least for now, the economic and political incentives for OPEC countries to lie about their spare capacity availability is not the driving force in causing the short-run global supply of oil to be more inelastic than expected.
So if OPEC is still able to pump oil on demand, why did we get the oil price spike in 2008?
Then answer is that OPEC’s spare capacity simply wasn’t enough to make the whole world’s supply more elastic.  The rest of the world’s oil producing countries are running full-tilt, producing as much oil as they possibly can as quickly as they possibly can.  There simply isn’t any additional spare capacity elsewhere on the world market.
In addition to this, there is the possibility that we’ve already hit the worldwide global peak in oil production and, outside of OPEC, the world’s available daily production capacity has already started to decline.  This is up for debate.  It will take a number of years before we can determine is this has actually happened, but what is obvious is that the world as a whole simply doesn’t have the additional spare capacity to increase supply as the price of oil spikes.

Just as the supply of oil is far more inelastic than we expected, the worldwide demand for oil has also changed recently to become far more inelastic and at the same time, the world demand for oil continues to increase, shifting the demand curve to the right.
The inelasticity of demand is largely due to the developing world.  In the developed world, oil is purchased by corporations and consumed by people like you and me.  We all need to make the business case for purchasing oil at higher prices.  If we can’t justify the benefit of purchasing more oil at $150 a barrel, we will simply use less oil.  This is why demand in the developed world isn’t extremely inelastic.
Most of the worldwide economic growth in the past decade, however, has come from developing countries, where oil is often purchased by the government and consumed by government-owned companies.  These government-controlled buyers don’t necessarily have to make the business case for purchasing oil at high prices.   As long as buying the oil will help their economy grow, these government agencies will purchase oil no matter how high the price is.  In other words, their demand is far more inelastic than in developing countries.  Because these developing countries as growing so rapidly and becoming such huge players in the world market, this is making the overall global short-run demand for oil far more inelastic.
The key player in all of this is China.  China has been experiencing rapid economic growth for the past decade.  Their GDP grew 10% just last year.  Last year China exceeded Japan as the second largest economy while at the same time exceeding the United States as the world’s largest consumer of energy.  Much of China’s growing demand for oil comes from the rising middle class, who are now beginning to reach a more western standard of living and many are beginning to purchase the ultimate symbol of western life: the automobile.  Car sales in china have been exploding recently.  In fact last year more cars were sold in China than in any other country at any other time in history.  If the number of cars per capita in China were to reach the level we have in the US, China would singlehandedly use all of the current world oil production.

China has an enormous demand for energy and has been importing more and more oil lately.  When we look at China’s oil consumption during the last oil price spike, we would have expected, based on the standard economic model that China would have decreased their oil consumption.  What we see, however is that instead of an expected short-run elasticity of demand of -.04, the elasticity of demand was actually slightly positive.  China continued to increase oil consumption, even during the spike, meaning their demand for oil is almost completely inelastic.
It wasn’t until the stock market crash in the US, and the corresponding reduction in demand for Chinese exports, that their oil consumption fell.  But I’ll talk about oil shock-induced demand destruction a little later.

So just to recap, the standard economist’s view of the supply and demand in the oil market is wrong.  What we see during the last oil shock is a far more inelastic supply of oil and a far more inelastic (and growing) demand for oil.  As you can see from this chart, Chinese oil demand continues to increase and as the US begins to exit the current recession, we see the US demand for oil beginning to return to its historic levels.  These two sources of demand will combine to shift the demand curve to the right and cause the oil price spike in the next few years.

Here’s what the supply and demand chart for oil actually looks like.  As you can see, the supply curve is not linear, but in fact runs into a wall of an upper limit on available spare capacity at around 87 million barrels per day of global oil production.  As the demand shifts to the right, as the developing world continues to demand more oil and as the US recovers from the recession, we see a spike in the oil price.  The production shifts out a little bit, but the price shifts up a lot.  This is the economic mechanism for an oil price spike.

Now the traditional economist’s view of the oil price spike is that we shouldn’t be worried because the high price will bring more production online and cause consumers to be more careful with their consumption.  Many economists believe that the oil price spike didn’t have a significant role in the 2008 economic crash.
But when we look at the data, we see that an oil price spike preceded almost every single economic downturn in almost every region of the world.  Clearly oil price spikes are damaging to our economy.

Why are oil price spikes so damaging?   The answer is that the use of oil permeates every aspect of our economic lives.  The primary use for oil, of course, is as a transportation fuel.  We use it as a fuel in our cars to get us to and from work, to get us out to dinner with friends, to get us to the mall to shop, etc.  About 9% of our oil consumption goes to jet fuel.  This allows us to take a vacation to see our relatives, but it also transports all kinds of “just in time goods” that we use on a daily basis – everything from sushi to flowers.  About a quarter of the oil we use goes to diesel fuel to truck around all of the other goods we consume and to bunker crude to ship all of our goods over the oceans to America.
The remaining 19% of the oil we consume goes into the products we use on a daily basis as a direct input.  All plastics are made directly from oil.  The asphalt roads we drive on are made from oil.  Many people still heat their homes with oil.  Oil is used for paints and pharmaceuticals and explosives and even the synthetic rubber in our car’s tires.
And then, of course, a lot of oil goes into the production of the foods we eat – from the oil-based pesticides and fertilizers used to grow the food, to the tractors and semi-trucks that plow, plant, harvest and deliver our food.
Everything you see around you is either directly made of oil or has been transported there by oil. 

What this all means is that as we endure an oil price spike, we have two types of demand destruction.
The primary demand destruction is what most economists talk about when they use the term “demand destruction”.  That is, as the price of oil goes up, the price of gasoline at the pump rises and people and companies begin to curtail their gasoline consumption.  Demand for oil is directly destroyed.
But at the same time, there is a second, and far more economically damaging, form of demand destruction taking place.  The secondary demand destruction comes from the increase in the price of all goods as the price of oil spikes.  Because oil is used as an input in almost everything we consume in our modern lives, as the price of oil increases, the price of all other goods goes up.  Everything from plastics to beef gets more expensive.
It’s been estimated that it takes 6 barrels of oil to raise one steer.  At $100 per barrel, this works out to about $1 per pound of beef.
So during an oil shock, the price of oil moves up quickly and at the same time, the price of almost every other good increases along with it.  Because wages don’t increase along with the price of goods, consumers have to spend more of their income on the necessities in life such as the gasoline needed to drive to work or the food on their dinner table.  This leaves the average consumer with less discretionary income to spend on other consumer goods, so when you aggregate this across the whole society, the demand for all goods goes down – thereby further decreasing the demand for oil.  This is what people are referring to when they say that high oil prices are a “drag on our economy”.

So why is there this secondary demand destruction and why is it so damaging to our economy?
The simple answer is that the average American is already on a tight budget.  75% of Americans live paycheck-to-paycheck and the majority are being squeezed by significant debt.  Because wages don’t increase along with the rapid increase of the price of goods during an oil shock, people simply have even less disposable income during an oil shock.  Because people are spending more of their budget on gasoline or food, they have less money to spend on clothes or DVDs or vacations.
Because 70% of the US economy is dependent on consumer spending, when consumers start spending less money on the non-essentials, the economy goes into a recession.  We see that the situation is similar in the UK, Germany and most other developed countries.  China has an economy that is less dependent on consumer spending, but because their economy is dependent on exporting goods to consumers in developed countries, when that demand goes away, they also enter a recession.
This is why oil price spikes are usually followed by global recessions.

There’s one caveat to my prediction of an oil price spike within the next two years.  There’s a very real possibility that the current economic recovery could fall back into a double-dip recession.  This would preempt an oil price spike by halting the increase in oil demand.
There are a lot of threats that could push us back into a recession.  In the United States we currently have about 10% unemployment and over 16% underemployment.  Our national debt has reached completely unsustainable levels and is not even being funded by China any more.  In fact China has recently become a net SELLER of treasury securities.  The Fed now purchases more government debt than every other foreign government combined.
The state and municipal debts are no better.  We could see a wave a municipal bond defaults which could push the market back into a recession.  Many state budgets are worse than our federal budget.  We could see a wave of state bankruptcies, and many state legislatures are currently debating changing their state constitutions to allow this.
Housing prices have also recently begun to double dip, which could push the market down as it did in 2008.
The situation in Europe is no better.  Governments like Portugal, Ireland and Greece are completely bankrupt.  There’s the possibility that this crisis could spread to Spain, which is too big of an economy for the EU to bail out – it’s essentially too big to fail – and it could bring down the Euro with it.
China has been growing so rapidly and pumping so much money into their economy that there’s a possibility that they’ve created a real estate bubble and a credit bubble.  We could see a repeat of the American credit crisis occur in China.

But assuming all of that doesn’t happen and assuming that we continue to grow out of this recession, I believe we will see an oil price spike within the next two years.
The million dollar question is: “can consumers handle oil over $100 per barrel”.  As we saw during the last oil price spike, there seems to be a ceiling of oil prices that the consumer simply can’t handle.
The current price of oil has already gone up 40% in the last 6 months.  We’ve seen Brent Crude oil break $100 per barrel last week and the US economy hasn’t even fully recovered yet!  Because the United States uses a quarter of the world’s oil, as we exit this recession, it will shift the demand curve to the right, causing an oil price spike.  We saw Dow reach 12,000 just last week – if economy continues to recover at this pace, we could see a price spike much sooner than expected.

So that’s how the oil supply and demand picture really looks, and why we’re probably going to see an oil price spike within the next two years.  If you want to read more, you can go to"