Running head: SUPPLY AND DEMAND FOR OIL 1

Supply and Demand for Commodities

Li Min Tu

Westcliff University

BUS 505: Managerial Economics

Professor Nima Salami

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July 12, 2020

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Supply and Demand for Commodities

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 SUPPLY AND DEMAND FOR COMMODITIES 2

Supply and Demand for Commodities

Price of oil in international markets has dropped stunningly 60% in the past twelve

months. Among the factors mentioned behind this drastic fall is the millions of barrels of oil

produced in the U.S. called shale oil (Guell, 2015). In the past, OPEC (Organization of the

Petroleum Exporting Countries) produced the largest oil output around the world and controlled

the oil market over decades since the 1970s. However, starting in 2011, with the revolutionary

extracting process of shale oil, a massive growth of oil production began in the U.S. Until today,

the United States has become the largest oil production country and has completely changed the

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oil market structure in the world.

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In this article, we will firstly talk about the supply and demand of the current global oil

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market. With a brief introduction to the background of OPEC and the current oil market
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structure, we apply the concept of supply and demand to analyze the oil price movements and

examine with the real world events. Finally, after price elasticity of the supply and demand in the
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short term and long term events being discussed, we will explain why shale oil could be a
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substitute for oil.

Oil Price Actions

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In the economics world, it is essential to discuss demand and supply. In the global oil

market, the supply is the countries that produce and export the oil. On the other side, the demand
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is the countries need to import the oil. The oil market is a typical oligopoly market structure
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because only a few countries can produce oil. When talking about oil prices, it is evitable to

mention the presence of OPEC. OPEC is an intergovernmental organization, consisting of 15 oil-

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rich countries, controls around 40% of world oil production (Razeka & Michieka, 2019). This

huge holding percentage in the oil production market makes OPEC a dominant position to

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 SUPPLY AND DEMAND FOR COMMODITIES 3

interfere with the behavior of global oil producers and thus somehow give it the power to

manipulate the global price. In the past, OPEC could almost decide the oil price, not until more

and more countries started to realize the importance of producing the oil. Nowadays, the

discovery of shale oil and the innovative evolution of fracking technology, making the United

States exceed Saudi Arabia and Russia in the oil production market.

There are countless factors that could impact the oil price. They can be categorized into

supply-driven and demand-driven reasons (Cashin, Mohaddes, Raissic & Raissic, 2014). For the

supply-driven determinants, political action is the most commonly seen. An oil producing

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country may limit the amount of oil exporting to another country or increase the oil price to

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achieve the political goal. The energy crisis in the United States in the last century falls in this

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case. Another determinant could be the outbreak of the war, a perfect example is the Iran-Iraq
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War in the 1980s. The war caused the destruction of Iranian oil facilities and disrupting oil

exports from both Iran and Iraq. The drop of the oil production causes the supply curve left
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shifting, which implies the rise of the oil price. The Shale Oil Revolution is an opposite example
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to the supply decrease. Starting in the mid-2000s, the new technologies in reducing the cost to

produce shale oil lead to the substantial growth in the production of shale oil. With the increase
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in the supply, the oil price started to drop starting in 2014.

As for the demand-driven side, the COVID-19 Pandemic stands for a good example.
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Because of the outbreak of the pandemic, people are not traveling as much as the old time. Ships
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are docked at the port and airplanes are forced to park in the run, leading to the huge decline in

demand. The oil prices recorded the hardest cut after 1991 (Albulescu, 2020), and even turned
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negative for the price of a barrel of West Texas Intermediate (WTI). The financial crisis in 2008

is also a good example for demand-driven oil price change (Kim, 2018).

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 SUPPLY AND DEMAND FOR COMMODITIES 4

The Speculators, defined as anyone who invests in something only to profit from the

fluctuations in its market value, also play an important role in determining the oil price. In the oil

market, speculators buy and sell contracts for oil (to be delivered later) without any intention of

using it. For example, a speculator purchases the oil future at the price higher than the current

trading price, this will make the supplier expecting higher profit in the future, thus decreasing the

supply in the current, which drives the oil prices up in the current market. Although speculations

are usually understood as a negative meaning, the actions of speculators actually help a lot in

stabilizing the oil price (Cologni, Scarpa & Sitzia, 2015).

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The Supply and Demand Picture for Oil

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While the oil price is considered to be volatile, the demand curve and supply curve are

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actually inelastic in the short term. Assume a person needs to drive a car for work every day, no
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matter how the oil price goes up, he will still need to drive to work. His car still consumes fuel

and cannot easily switch another energy. The airplanes, the ships, and all the transportations need
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to operate as normal. Likewise, when the oil price is cut half, this person will not drive twice as
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far and the airplanes will not fly any longer or further. The abrupt change in price only has a

small impact in demand. Supply in respect to oil is also inelastic in the short term. The majority
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of the costs in an oil field come from the early fundamental construction including prospecting,

building the factory and placing the oil rigs. Once the infrastructure is put in place, the actual
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cost to pump the oil into barrels is relatively low. The cost is roughly the same thereafter no
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matter it is producing at full capacity or at half of capacity. Therefore, producers will tend to

pump at the maximum sustained capacity.

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Contrary to the short term situation, the demand curve would be elastic in the long run. If

the rise in the oil price is foreseeable, the whole nation will try to reduce the consumption of the

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 SUPPLY AND DEMAND FOR COMMODITIES 5

oil. Policymakers may establish new regulations in limiting the use of fuel. This scenario can be

examined in the past during the oil crisis in the 1970s (Baumeister & Kilian, 2016). During that

time, the U.S. government introduced a national 55 mph speed limit and mandated stricter fuel

efficiency standards in order to reduce the gasoline consumption. Companies will put more effort

in researching alternative energy to reduce the dependence on oil. The best example would be the

emergence of Tesla. Tesla changes the automotive market and fosters the speed for electrical

vehicles popularity, leading to more and more electrical vehicles at an affordable price. If the oil

price continues to rise, consumers will replace their cars with electrical vehicles without

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hesitation and reduce the demand in gasoline. In other words, reduce the demand for oil.

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The Impact of Shale Oil in the United States

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The shale oil revolution happening in early 2010s was exciting news. It gave the U.S. a
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potential to change the global oil market. In fact, in 2020, the U.S. has become the first place in

the oil production countries. Shale oil is a good substitute to crude oil. With the increasing
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production volume in shale oil in , the demand in importing crude oil from other countries will
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gradually decrease. Considering the concept of cross-price elasticity of demand, given all the

factors the same, only the price can be changed. When the price of crude oil increases,
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consumers will decrease the demand for crude oil, and start seeking other alternatives, which can

satisfy their demand with a lower price. Though the cost in producing shale oil is high compared
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to producing crude oil, it is still cheaper to produce yourself rather than to import from outside,
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not to mention the oil price is controlled in other’s hands. However, the U.S. cannot get rid of the

dependence on OPEC (Salameh, 2013). Shale oil is categorized as light oil. It is perfect for
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making gasoline but not the best for diesel or jet fuel. The infrastructure to transport or move the

oil is inadequate in the U.S. The more realistic reason is that the demand in oil is greater than the

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 SUPPLY AND DEMAND FOR COMMODITIES 6

production of oil in the U.S. It is near impossible, or at least extremely difficult to achieve self-

sufficiency in oil. Therefore, it is important for the U.S. to find a way to live peacefully with

other oil producing countries or the news like Russia Saudi Arabia oil price war will repeat again

and again.

Summary

In the paper, we discuss the oil market structure and the influence of OPEC. Although

OPEC does not have that huge influence as it used to, it still has the certain power to set the oil

price by affecting the global relationship. Also, the oil price is very volatile which is examined

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by a couple of historical events mentioned in the paper. Though the oil price is volatile, the

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supply and demand curve is not easily affected by the volatility. The supply curve and demand

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curve are considered to be inelastic in the short-term event. On the other hand, the demand curve
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is elastic in the long-run. Finally, we explore the impact of shale oil in the United States. Shale

oil production has a positive effect on domestic oil production and decreases the dependence to
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other oil producing countries. However, the U.S still needs to rely on oil import because it is not
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possible to achieve self-sufficiency.

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 SUPPLY AND DEMAND FOR COMMODITIES 7

References

Albulescu, C. (2020). Coronavirus and Oil Price Crash. SSRN Electronic Journal.

http://dx.doi.org/10.2139/ssrn.3553452

Baumeister, C., & Kilian, L. (2016). Forty years of oil price fluctuations: why the price of oil

may still surprise us. Journal of Economic Perspectives, 30(1), 139–160.

http://dx.doi.org/10.1257/jep.30.1.139

Guell, R. C. (2015). Issues in economics today (7th ed.). New York, NY: McGraw-Hill Education

Kim, M. S. (2018). Impacts of supply and demand factors on declining oil prices. Energy, 155,

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1059–1065. https://doi.org/10.1016/j.energy.2018.05.061

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Razek, N. H. A., & Michieka, N. M. (2019). Opec and non-opec production, global demand, and

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the financialization of oil. Research in International Business and Finance, 50, 201-225.
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https://doi.org/10.1016/j.ribaf.2019.05.009

Scarpa, Elisa, Cologni, A. & Sitzia, Francesco G. (2015). Big fish: Oil markets and speculation.
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Fondazione Eni Enrico Mattei Working Papers. Paper 996.

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https://services.bepress.com/feem/paper996

Salameh, M.G. (2013). Impact Of Us Shale Oil Revolution On The Global Oil Market, The Price
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Of Oil & Peak Oil. Retrieved from

https://www.iaee.org/en/publications/newsletterdl.aspx?id=202
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