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Development in Oil Crude Market

Richie Patel
Venkatesh Sunkireddy

Introduction
The modern petroleum industry began in 1859, when the American oil pioneer E. L. Drake
drilled a producing well on Oil Creek in Pennsylvania at a place that later became Titusville.
Many wells were drilled in the region. Kerosene was the chief finished product, and kerosene
lamps soon replaced whale oil lamps and candles in general use. Little use other than as lamp
fuel was made of petroleum until the development of the gasoline engine and its application to
automobiles, trucks, tractors, and airplanes. Today the world is heavily dependent on petroleum
for motive power, lubrication, fuel, dyes, drugs, and many synthetics. The widespread use of
petroleum has created serious environmental problems. The great quantities that are burned as
fuels generate most of the air pollution in industrialized countries, and oil spilled from tankers
and offshore wells has polluted oceans and coastlines.
Current condition
Oil is in the middle of one of its steepest selloffs since the financial crisis, with prices on the
international market falling to $94 a barrel on Sept. 30 2014 and to $75 in mid November 2014.
There are two explanationsnot enough demand or too much supply. Supporting the weak
demand argument: a stagnant economy in Europe, slower growth in China, and flat gasoline
consumption in the U.S. According to the International Energy Agency, in 2014 world demand
for oil will grow only 1.5 percent. But the bigger factor appears to be surging global oil
production, which outpaced demand last year and is shaping up to do so again in 2014. To try to
keep prices high, Saudi Arabia, the worlds biggest petroleum exporter, has reduced its oil
production from 10 million barrels a daya record highin September 2013 to 9.6 million as of
Sept. 30 2014. That hasnt done much to raise prices, mostly because other OPEC countries are
pumping more crude as the Saudis try to slow down. Sharply higher production increases from

Development in Oil Crude Market


Richie Patel
Venkatesh Sunkireddy

Libya and Angola, along with surprisingly steady flows out of war-torn Iraq, have pushed
OPECs total output to almost 31 million barrels a day, its highest level this year and 352,000
barrels a day higher than last September. Combined with the continued increase in U.S. oil
production, the world has more than enough oil to satisfy current demand.
Oil prices
Both the demand and supply of oil are relatively inelastic in the short run: changes in price have
little impact on either the quantity demanded or the quantity supplied. When oil prices rise we
spend considerable time and energy complaining but at least in the short run, spend almost no
effort in trying to adjust our habits to consume less. Similarly changes in price do little to spur
new supplies in the short run. Exploring for, drilling, and bringing new sources on-line can take
many years. Since the quantities demanded and supplied change very little as prices rise and fall,
both curves are relatively vertical as shown below:

Price

Supply

P0
Demand
Quantity
Q0

Because quantities are relatively fixed in the short run, any shifts in demand or supply will cause
large changes in prices. For example, suppose that supply falls. The decreased supply creates a
temporary shortage that will begin to drive up price. If demand is elastic, only a small increase
in price will be needed to get consumers to cut purchases enough to meet the new reduced

Development in Oil Crude Market


Richie Patel
Venkatesh Sunkireddy

output. However, if demand is inelastic, it will take a much larger price increase to generate the
needed cut in quantity demanded.
The graph on the left below illustrates the elastic demand case. The demand curve is relatively
flat and the drop in supply (from S to S') causes only a small increase in price (from P 0 to P1).
However, if the demand curve is less elastic or more vertical (as in the graph on the right), the
same cut in supply causes a much larger increase in price.

Elastic Demand

Inelastic Demand

S'

S
P1
P0

S'

P1
D

P0
D

Q0

Quantity

Q0

For many years members of the Organization of Petroleum Exporting Countries (OPEC) have
controlled most of the world's oil market.4 In the early 1970's, partly reacting to political turmoil
in the Mideast, OPEC oil ministers voted to deliberately cut production. As illustrated above,
this shifted the supply curve for oil to the left and drove up prices. Because demand was
inelastic, the price increase was significant. The higher prices OPEC countries received more
than offset the lower sales and their oil revenues rose rapidly. In 1979 a bitter war between longtime enemies Iran and Iraq shut down more oil fields and caused additional price increases.
Demand and supply are far more elastic in the long run than in the short run. After oil prices
rose, firms began shifting to less energy-intensive ways of manufacturing goods and services.

Development in Oil Crude Market


Richie Patel
Venkatesh Sunkireddy

Similarly, consumers started to conserve as well. They insulated homes heated by oil furnaces
and shifted to alternative energy sources. More importantly, they began buying different types of
cars. They gradually ditched the gas-guzzlers they purchased in 1971 when fuel prices were not
an issue and bought smaller, more fuel-efficient vehicles. As we shifted from cars getting 12
miles per gallon to ones getting 28 miles per gallon, the demand for gasoline (and its price)
began to fall.
Increased demand from U.S. motorists, from other countries, and from speculators worried about
even higher prices in the future, coupled with supply cuts in Iraq and Nigeria caused oil prices to
increase. However, by late 2008 problems in U.S. mortgage lending set off a crisis in global
financial markets that led to a global economic slowdown. The slowdown, in turn, caused a drop
in demand for oil and began pushing the price of oil back down. Once prices began to fall,
speculators who had purchased large volumes of oil expecting to be able to resell at higher future
prices began to lose money rapidly. To cut their losses they dumped their supplies on the market
hoping to unload them quickly before prices fell further. Of course, this increased market supply
and drove down prices even more rapidly. Oil prices that peaked above $140 per barrel in July
2008 had fallen to a mere $40 by December. Unrest in the Middle East, accentuated by popular
uprisings in Tunisia, Egypt, Libya, Yemen, Bahrain and Syria refueled speculative fears. As
firms rushed to lock in supplies, demand surged and prices soared back above $100 per barrel.
By May 2011 domestic gasoline prices once again approached $4.00 per gallon. Most expect the
Mideast crises to stabilize and for oil prices to bump back down. But, given the political
instability in the many major oil-exporting nations, coupled with inelastic demands and supplies
in the short run, the roller coaster price rides of recent decades are likely to continue.

Development in Oil Crude Market


Richie Patel
Venkatesh Sunkireddy

Some argue that the government should step in and mandate lower prices. Such schemes pander
to populist preconceptions, but make little economic sense. Suppose the government decides to
lower gasoline prices by decree and forbids firms from charging any price higher than P 1 in the
graph below. In economic jargon, P1 becomes a ceiling price. Consumers immediately react to
the lower price by increasing their quantity demanded from Q0 to Q2. However firms react in the
opposite way. Stuck with a lower price they reduce their quantity supplied from Q 0 to Q1 and a
shortage results. The quantity demanded (Q2) now exceeds the quantity supplied (Q1).
Price

Supply

P0
P1

Ceiling price
Demand
Quantity
Q1 Q0 Q2

Some consumers do get gasoline for a lower price, but others get no gasoline at all. Since
output has been cut from Q0 to Q1 there is less gasoline to go around. It simply is not profitable
to produce as much at the lower price. Who gets the gasoline and who does not? In a free
market consumers would compete for the scarce gasoline by offering higher prices; those willing
to pay the most would get the gasoline. However, with a price ceiling in effect, paying higher
prices is illegal. Firms and consumers must find a different way to decide who gets the gas and
who does not.
Demand, supply and market equilibrium are big parts of the study of economics. This current
issue is tightly related to these three economic concepts. There is no doubt that the oil market
equilibrium is fragile and oil prices are constantly fluctuating. Globally, almost everything

Development in Oil Crude Market


Richie Patel
Venkatesh Sunkireddy

requires oil-derived products to function which leads to all the price hikes and drops which
eventually results in many side effects, good and bad ones. To worsen the situation, the Earth is
running out of natural resources and if mankind does not figure out a way to preserve these
resources, especially oil, the prices ought to hike higher. In the end, the global economy will
become a massive disaster.
Conclusion
Oil prices are volatile in the short run because demand and supply are inelastic. This is due to the
fact that there is a limited supply of oil, which means any disruption to supply, will shift the
supply curve to the left, resulting in a sharp increase in price. In terms of demand, prices are
volatile because at present there are no readily available substitutes to using oil, so an increase in
demand, such as from developing nations, will shift the demand curve to the right also causing a
sharp increase in price. Oil prices in the short run are therefore very sensitive to changes in
demand and supply. In the long run oil supply and demand is elastic, because future alternatives
give the potential for reduced demand and increased supply.