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INTRODUCTORY ECONOMICS

ECON1000

INDIVIDUAL ASSIGNMENT Article: “Oil Prices: What’s Behind the Plunge?”

NGUYEN THANG HUNG STUDENT ID 17974435 TUTORIAL CLASS: THURSDAY 2PM TUTOR: DR. CHARLES WANG

  • A. ISSUES & THEORY

    • 1. Article Summary

The article “Oil Prices: What’s behind the plunge?” discusses the reasons behind the fall in oil prices in the recent weeks, which sequentially causes the new downturn for the oil industry as well as global economic challenges. The price of a single barrel of oil has

plummeted down to $45 a barrel, circa half since June 2014, making it tantamount to the levels last observed during the abyss of Great Recession - the ensuing global recession in

  • 2009 (Krauss 2015). Despite being characterized by its volatility and a history of incessant

ups and downs, the oil industry is predicted to take years before oil prices return back to the norm of the past decade, which marks approximately $115 per barrel. The twofold increase in United States domestic production over the last six years is believed to have precipitated the plunge in oil prices, as it diverts the market for Saudi, Nigerian and Algerian oil from US to Asia, forcing the producers to reduce prices (Krauss 2015). The overgrowth in supply is also the result of the rising Canadian and Iraqi oil production, as well as the continual pumping from Russia despite her current economic setbacks.

The supplementary article “Short-term Energy Outlook” further support this line of cause- effect reasoning when indicating that global oil inventory builds in the second quarter of

  • 2015 averaged at 2.7 million barrels per day (b/d), rising by 0.8 million b/d compared with

the first quarter of the year (Pearson 2015). The abundance of supply over weaker demand

resulted from the weakening of global economies as well as vehicles are becoming more energy-efficient is believed to have jointly precipitated this 2.7 million b/d surplus in oil production.

  • 2. Introduction

This essay sets out to identify and explain the underlining economic theories relevant to the global crude oil market. It starts off by discussing the basics of demand and supply, including their price elasticity, the factors causing the shifts in both curves as well as the resulted surplus. The focus will thereafter shifted on to the examination of the impact that falling oil prices exert on the market of its complementary products together with its macro economic problem of unemployment. The discussion will then conclude by putting the spotlight on the perceived winners and losers of this plunge in oil prices, as well as the expectations on the short-term and long-term future of crude oil prices.

B.

ANALYSIS

1.

Demand

The demand curve represents the inverse relationship between the quantity demanded of a good and its price, as stated by the law of demand, demonstrated by the downward sloping of the curve, where quantity demanded decreases as price increases (Hubbard et al. 2013). Various non-price variables can exert impact on demand, such as preference, price of substitutes or complementary goods, purchasing power, future expectations, as well as number of consumers (Hubbard et al. 2013).

With regards the current market for crude oils, Income of consumers are decreasing as the result of insipid China-led global economic slowdown, weakening their purchasing power and sequentially shifting the demand curve left (Hubbard et al. 2013).

Global oil forecasts’ analysis indicates the reasonable likelihood of a further plunge in future oil prices, judging by the constant oversupply of crude oils in the market that appears to continue for the time being. This implies an expectation of even lower oil prices in the

future, causing oil consumers to be hesitant and reluctant to purchase oil at the moment, leading to a further decrease in demand.

Vehicles are becoming more energy-efficient and thus they consume less and less fuel (Krauss 2015). Technological advancement allows more vehicles to operate on non-oil energy sources, such as gas, or electricity. This increase in availability of substitutes and a decreased number of oil buyers will again, cause the demand curve to shift left.

DIAGRAM OF DEMAND SHIFTING LEFT

Price (US$ per barrel)

Supply crude oil P 1 P 2 Demand crude oil (1) Demand crude oil (2) Q
Supply crude oil
P
1
P
2
Demand crude oil (1)
Demand crude oil (2)
Q 2
Q 1

Quantity (millions of barrels per day)

2. Supply

On the other hand, the supply curve is a representation of the law of supply, which asserts that a product’s quantity supplied will increase/decrease when its price increases/decreases, ceteris paribus (Curtin University 2014). Any shift in supply curve is likely to be the result of changes in non-price determinants such as technology, input prices or cost of production, number of sellers as well as future expectations on prices.

The article acknowledges that the twofold increase in United States domestic production of crude oils and the nation’s spike in oil supply on the back of shale exploration together with its growing offshore production due to project startups, have pushed the overall production to a highest level observed in the past four decades. Technological advancement in oil production has allowed US to increase significantly. The newly developed method of hydraulic fracturing, which involves releasing oil and natural gas from shale by pumping processed water and sand into wells, sequentially increases the crude oil supply and shifts the supply curve further right.

DIAGRAM OF SUPPLY SHIFTING RIGHT

Price (US$ per barrel) Demand crude oil Supply (2) crude oil (1) Supply crude oil 115
Price (US$ per barrel)
Demand crude oil
Supply
(2)
crude oil (1)
Supply crude oil
115
45
91.96 95.73

Quantity (millions of barrels per day)

Expected future prices have significantly affected the oil supply. The oil prices are forecasted to plunge further as time goes and to experience a major drop in the year 2016 due to the following reasons.

The global market-share war between OPEC and US shale producers: OPEC’s policy of not cutting down on production to fight for market share against its rival further pushes the supply curve right. The cartel of oil-exporting nations finds itself in a much weaker position than before as its output accounts for merely 40 percent of global crude oil supply, making a decline in production to keep the price high a fatal decision. OPEC’s core Middle East producers are pumping at a record rate of 31.6 million barrels a day and have shown the intentions to increase supply further to defend its share of the global oil market against other players, mainly US shale producers.

The potential return of Iranian crude: the P5+1 and Iran announced an agreement that gradually removes the Western nuclear-related sanctions off Iran and could possibly lead to the nation’s total sanctions relief in the middle of the year 2016 (Pearson 2015). Analysts have recently expressed the view that the sanction relief would result in the additional oil supply from Iran into the massively oversupplied oil market and would sequentially cause tensions within OPEC and depress the oil price even further (Wenkel 2015).

In light of these recent and up-coming events, oil producers are expecting an even greater increase in global oil supply and a deeper cut in future oil price. As such, this shifts the supply curve to the right in anticipation of lower prices in the near future.

The new downturn for oil industry has resulted in slower demand for oil’s complementary goods such as drilling and production equipment. Recent plunge in oil prices have exerted significant impact on oil companies, causing them to curtail spending on production (except US and OPEC as they continue to maintain high level of production). As a result, demand for oil drilling equipment is expected to undergo a period of weakness, shifting the demand curve to the left (Cookson 2015).

DIAGRAM OF DEMAND FOR DRILLING AND PRODUCTION EQUIMENT SHIFTING LEFT

Price (US$ )
Price (US$ )
Supply production equipment P 1 P 2 Demand production equipment (1) Demand production equipment (2) Quantity
Supply production equipment
P
1
P
2
Demand production equipment (1)
Demand production equipment (2)
Quantity (per year)
Q 2 Q 1

A surplus happens when the quantity supplied exceeds the quantity demanded of a good (Hubbard et al. 2013). The article highlights the global oil inventory builds in the second quarter of 2015 averaged at 2.7 million b/d, rising by 0.8 million b/d compared with the first quarter of the year (Pearson 2015).

DIAGRAM OF SURPLUS Price (US$ per barrel) Surplus = 2.7 million b/d Supply crude oil 45
DIAGRAM OF SURPLUS
Price (US$ per barrel)
Surplus = 2.7 million b/d
Supply crude oil
45
P
Demand crude oil
Quantity (millions of barrels per day)
93.03
Q
95.73

The aforementioned surplus could diminish and eventually dissipate if producers decrease the price of crude oil. This would eventually boost the quantity demanded, as more buyers are willing to purchase at the new lower price.

This is likely to take place, as OPEC and US show no sign of cutting down on production due to their war on global market share and the additional Iranian oil in the middle of 2016 will likely depress the oil prices down further (Mudge 2015). For the time being, the surplus is here to stay at least until the sanctions relief on Iran is entirely removed.

3. Price Elasticity and Total Revenue of Crude Oil

The price elasticity of demand refers to the responsiveness of quantity demanded of a good to a change in its price (Hubbard et al. 2013). Crude oil remains one of the major energy sources, accounting for 34% of global energy consumption, second to none. As such, consumers’ willingness to pay for crude oil is unlikely to stumble considerably when a change in price takes place (Graves et al. 2009). Hence, despite the plunge in oil prices, the demand for oil will only respond very weakly, demonstrating a price-inelastic demand.

Total revenue represents the total amount that sellers receive from buyers when selling goods (Curtin University 2014). As the demand for crude oil is rather price-inelasticity, the quantity demanded increases insignificantly.

DIAGRAM OF TOTAL REVENUE

Price (US$ per barrel) Demand crude oil Supply (2) crude oil (1) Supply crude oil Loss
Price (US$ per barrel)
Demand crude oil
Supply
(2)
crude oil (1)
Supply crude oil
Loss in revenue
115
45
Gain in revenue
91.96 95.73

Quantity (millions of barrels per day)

The loss in total revenue (US$6.44 billions per day) is way more significant than the gain (US$170 millions per day), as such with demand being price-inelastic, the plunge of oil price brings about a considerable loss in earnings for oil producers.

4. Market efficiency

Consumer surplus is the difference between the highest price that he/she is willing to pay and the real price being paid. On the other hand, producer surplus is the difference between the lowest price a supplier is willing to accept and the real price it receives (Hubbard et al. 2013). With regards to crude oil, the abundance of supply in global market has shifted the supply curve to the right as explained previously, causing consumer surplus to increase by area (B + C + D) from the initial area A, while producer surplus decreases by area B and increases by area (F+G) from the initial area (B+E)

DIAGRAM OF MARKET EFFICIENCY

Price (US$ per barrel) Demand crude oil Supply crude oil (1) (2) Supply crude oil A
Price (US$ per barrel)
Demand crude oil
Supply crude oil (1)
(2)
Supply crude oil
A
P
1
B
C
D
P
2
E
F G
Quantity (millions of barrels per day)
Q 1 Q 2

As noticed through the above diagram, the party gaining the most is consumers as it has larger increase in its surplus.

C. CONCLUSION

Inarguably, the current plunge in oil prices brings about a mixed pool of goods and bads.

In the short-term

Households benefit from this sharp cut in oil prices as prices of gasoline, diesel, heating oil as

well as natural gas fell significantly. This price drop is also disproportionately helping lower- income groups, as fuel costs take up a major share of their restricted earnings.

Economic and even political turbulence are to be observed in oil producing countries and states such as Iran, Russia, Brazil, Nigeria and Ecuador. Persian Gulf’s aid to various countries such as Egypt and global investment is likely to be cut. Major oil producers are slashing their payrolls to save cash while smaller ones are cutting their dividends, liquidating assets as net losses are experienced. Some minor firms leverage heavily and are likely to go bankrupt.

In the long-term

The aforementioned events of market-share war and the up-coming return of Iranian oil project a future of even lower oil prices. Households are expected to surfer if oil prices continue to remain low, as it would result in firms cutting expenditure such as wages to

reduce losses. Smaller oil producers might go out of business and possibly lead to massive unemployment causing households significant loss in disposable income.

Eventually, minor players will go out of business and oligopoly or even monopoly market structure for crude oil will sequentially emerge where only a few major players remain in the market and take significant control and dominance over oil production and prices. This market structure comes with possible drawbacks that have the likelihood to hurt global economies in significant and damaging ways.

Conclusively, oil prices are perceived to remain all-time low at least until there is greater clarity around two factors: a resolution to the Iran’s sanctions relief and a sustained decline in US oil production. Demand for fuels is on its track to recover in some countries but it would take a significant while for demand to outstrip or balance with supply. Winners of today could lose tomorrow. “The history of oil is of booms and busts followed by more of the same.”

D. REFERENCE

Brennan, Andrew. 2014a. “Lecture 2: Demand and supply.” PowerPoint lecture slides. https://lms.curtin.edu.au/webapps/portal/frameset.jsp?tab_tab_group_id

Brennan, Andrew. 2014b. “Lecture 3: Elasticity.” PowerPoint lecture slides.

https://lms.curtin.edu.au/webapps/portal/frameset.jsp?tab_tab_group_id=_4_1&url

2Fwebapps%2Fblackboard%2Fexecute%2Flauncher%3Ftype%3DCourse%26id%3D

6480_1%26url%3D

Cookson, Colter. 2015. “High-spec land rigs, drilling equipment advances providing key in shale plays.” The American Oil & Gas, August 31.

Graves, Philip E. and Robert L. Sexton. 2009. "CROSS PRICE ELASTICITY AND INCOME ELASTICITY OF DEMAND: ARE YOUR STUDENTS CONFUSED?" American Economist 54 (2): 107-110. http://search.proquest.com/docview/603216498?accountid=10382

Hubbard, Glenn, Anne M. Garnett, Philip Lewis, and Anthony Patrick O’Brien. 2013. Essentials of Economics. 2nd ed. Frenchs Forest, NSW: Pearson.

Krauss, Clifford. 2015. “Oil Prices: What’s Behind the Plunge?” The New York Times, August

28.

Mudge, Rob. 2015. “People will not accept crappy terms for Iranian oil.” Deutsche Welle, July

30.

Pearson, Jessica. 2015. “Short-term energy outlook.” Energy Information Administration, August 11.

Wenkel, Rolf. 2015. “Oil prices sinking even without Iran.” Deutsche Welle, July 30.

Zhou, Moming. 2015. “Speculators Retreat from Oil as OPEC oversupply crowds out shale.” Bloomberg Business, June 22.