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  
 

P1    

 
P2  
 

 
Demand  crude  oil  (1)  
Demand  crude  oil  (2)    

Quantity  (millions  of  barrels  per  day)  

Q2   Q1  
 

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  crude  oil  (1)   Supply  crude  oil  (2)    

 
115  
 

45    

 
Quantity  (millions  of  barrels  per  day)  
91.96   95.73  
 

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$)  
 
Supply  production  equipment    
 
 
 
P1    
 
 
P2  
 
 
Demand  production  equipment  (1)    
Demand  production  equipment  (2)    
 
 
 
Quantity  (per  year)    
Q2   Q1  
 
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  
 
 
 
 
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  crude  oil  (1)   Supply  crude  oil  (2)    
 
Loss  in  revenue    
 
 
115    
 
 
 
 
 
 
45  
 
Gain  in  revenue    
 
 
Quantity  (millions  of  barrels  per  day)  
91.96   95.73  
 
 
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)   Supply  crude  oil  (2)    
 
A    
 
 
P1  
 
 
 
B  
 
 
C   D    
P2  
E   F   G    
 
 
 
Quantity  (millions  of  barrels  per  day)  
Q1   Q2  
 
 
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.