Introduction to Energy Markets

Energy Prices

Weekly UK Wholesale Electricity Price

2013

Thomson Reuters: ICE Exchange

APX Power Market

Economic Models – Help Understand Market Outcomes

Basic Building Block Supply and Demand

Introduction to the Price Mechanism
Theory of Supply
Supply Curve – Firm and Market

Theory of Demand
Individual WTP and Market Demand

Today
Price Determination
Basic D&S Analysis: Subsidies and Taxes
Price Elasticities of Supply and Demand
Short versus Long Run
D&S and Oil Price Volatility
 Firm’s Marginal Cost Curve
$65

$35

$15

Quantity (m barrels)

Oil price $35 per barrel, Firm produces 3m barrels/day

What if Oil price $15/ barrel?
What if Oil price $65 / barrel?
Market Level – Sum of Individual Firms Supply Curves

. . . . . . . . .
. . . . . . . . .
. . . . . . . . .

Large No. Firms in Industry – Approximate Smooth Market Supply Curve

Price
S0

Quantity
 Change/Movement in Supply Function

Main Factors
Technology
Prices of Factors of Production
Prices of Related Goods produced
The Number of Suppliers

Shifts Supply Curve Inward or Outward (Right or Left)

Price
S0

S1
Market P*
Price Technology
e.g. New Invention reduces
costs
Increase supply at given price –
Outward shift

Quantity
.
Qs 0 Qs 1
Theory of Demand: How do consumers decide what to buy?

Economic Model

Assume
Individuals have preferences over goods & services

Given choice can express preference

‘Satisfaction’ from consumption of good falls as more of good is

consumed

Willingness to Pay (WTP) – maximum amount individual willing

to sacrifice to consume unit of good
 WTP Curve defined Individual’s Demand function
Say Price Heating Each Room £1.50 per day. £0.7 per day?
How many Units of Heat would Homeowner buy?

Quantity WTP £ Price £

Heat per day Per unit
(Units)
1 3 1.5
£1.5
2 2 1.5
3 1 1.5
£0.7
4 0.75 1.5
5 0.25 1.5

Law of Demand Quantity

The higher the price the lower the quantity demanded, all other Heating
things remaining equal. Consumed

Note Quantity demanded – point on WTP/Demand Curve.

Demand = Demand Curve/Schedule
Market Level – Sum of Individual Demand Curves

. . . . . . . . .
. . . . . . . . .
. . . . . . . . .

Price
Large No. Individuals in Market – Approximate Smooth
Market Demand Curve

Quantity
 Other Determinants of Demand
If other factors change induces Change in Demand Curve

Impact – Shifts Demand Curve Inward or Outward (Left or Right)

Example Income Increase

Price

Market P0
Price
D1

Do

Quantity
Qd0 Qd1
Market Equilbrium
How do Prices coordinate Consumption & Production Plans?

Market Equilibrium – Q demanded = Q supplied

How? Prices adjust until plans match.

Adam Smith’s ‘Invisible Hand’

Interaction-Law Demand & Supply
 Price
.
Outcome - Competitive Market e.g. Oil
Supply

Pe

Demand

Quantity
Qe
At Pe Market Equilibrium Qd  Qs  Qe
Adam Smith’s ‘Invisible Hand’
Say price ‘too high’ Q supplied > Q demanded (Surplus)
Suppliers have unsold stock. Bids prices down.
P↓ Q demanded ↓ Q Supplied ↑

Say price ‘too low’ Q demanded >Q supplied (Shortage)

Not all Consumers able to buy at current price. Bids prices up
P↑ Q demanded ↑ , Q Supplied ↓

Price adjustments - Q demanded & Q supplied balance

.
Role of Prices
Anonymous trade
Separates economic activity into production & consumption
Provide information
Reflect relative scarcity
Provide incentives

Coordinate Consumption & Production plans

D&S Framework – Predictions

 .
Predictions - Impact on market if Consumer
Incomes Increase
Price

Original Market P 0 , Q 0
e e
S0
Equilibrium

Pe1 Income Increase

shifts Demand Curve
Pe0 to Right D0 to D1

D1
New Market Pe1 , Qe1
D0 Equilibrium

0
Quantity
1
Q Q
e e
Petroleum Subsidies and Taxes

Subsidies
Many developing countries – control domestic prices
e.g. China – Price Ceiling on Petroleum Products

Taxes
Developed Countries – Indirect Taxation Petroleum Products
e.g. UK Fuel Duty – 4% all Government Revenues (£27bn)

Energy Subsidies Overall - International Monetary Fund

(IMF)
Price < Cost of Supply + Environmental cost
6.5% Global GDP

How Large Are Global Energy Subsidies? IMF Working

Paper WP/15/105
https://www.imf.org/external/pubs/ft/wp/2015/wp15105.pdf
. How Large Are Global Energy Subsidies? IMF Working Paper WP/15/105
https://www.imf.org/external/pubs/ft/wp/2015/wp15105.pdf
 Basic D&S Analysis – Price Ceiling
“China’s fuel price rise biggest for almost three years” March 19,
2012, Financial Times http://www.ft.com/cms/s/0/436395e8-71db-11e1-8497-00144feab49a.html#axzz3qSrDClOf

No Price Ceiling
Price

S0

Original Market Pe0 , Qe0

Equilibrium
Pe0

D0

0
Quantity
Q e
 Price Ceiling – Maximum Price P
Price

Original Market P 0 , Q 0
e e
S0
Equilibrium

New Market
P , Qd1  Qs1
Outcome
Pe0
P
P
“Shortage” Rationing
D0

0
Quantity
1 1
Q s Q
e Qd

Subsidized Imports?
Indirect Petroleum Taxes - Who Pays? Simple?

Tax Incidence – division of the burden of the tax between

buyer & seller

Example Tax on Sellers

No Tax Equilibrium P =£40, Qd=Qs= 20

Tax £20 per unit sold on Seller

If no changes in Market
Qs= 20, P =£60,
Price received by seller =£40
Equivalent to Supply Curve Change
 No Tax
Original Market
Price Pe0  40, Qe0  20
Equilibrium

S0

Pe0  40

D0

Quantity
Q  20
0
e
Tax £20 per unit sold on Seller - Equivalent Supply Curve Move
Price S1
Pe0  40, Qe0  20

S0
Out of equilibrium –
60
Consumers not
willing to buy 20 units
at £60/unit
40

D0

Quantity
20
Tax £20 per unit sold on Seller - Equivalent Supply Curve Move
Price S1

Old equilibrium
S0

50 Pe0  40, Qe0  20

New equilibrium
30
Pe1  50, Qe1  15

D0

Quantity
15 Buyers pay £10 more
Sellers receive £10 less
Buyer & Sellers share burden of tax
Impact of less “Responsive” Demand Curve
Price S1
Old equilibrium

S0 Pe0  40, Qe0  20

55
New equilibrium

35 Pe1  55, Qe1  17

Buyers pay £15 more

Sellers receive £5 less
D0
D1
Quantity
17
How burden is shared depends on “Responsiveness” of Qd
Demand & Supply Framework Predictions
– Qualitative
– Quantitative

Elasticities - Responsiveness measures

Unit Free
Easy interpretation
Widely Applicable Concept Price, Income etc

Price Elasticity of Demand

Percentage Change in quantity demanded

Percentage Change in price
% Qd
% P
Example Price (P)

Original P =30, Qd=50

Note.
New P =60, Qd=40
Convention Average P =45, Qd=45
express
changes as %
of average
price/quantity

Quantity (Q)

% Qd 50 40 / 45 0.222 % P 30 60 / 45 0.667
Price elasticity of demand = (0.222/0.667) = -0.333
If Price Increases by 1%, Q demanded Decreases by 0.333 %
 Percentage Change in quantity supplied
Price Elasticity of Supply
Percentage Change in price
% Qs
% P
Example
Price (P)
Original P =30, Qs=50
New P =50, Qs=60
Average P =40, Qs=55

% Qs 60 50 / 55 0.1818
% P 50 30 / 40 0.5

Price Elasticity of Supply =0.364

If Price Increases by 1%
Quantity supplied increases +0.364%
Quantity (Q)
Properties & Determinants

Classification
Elasticity >1 Elastic
Elasticity < 1 Inelastic

Example Price Elasticity of Demand

Elastic % Qd
1 means % Qd % P
% P
If Price Increases by 1% Q demanded decreases > 1%
% Qd
Inelastic 1 means % Qd % P
% P
If Price Increases by 1% Q demanded decreases < 1%
Price Elasticity of Demand
-Number and closeness of substitutes
-Habit-forming Goods
-Proportion of income spent on good;
-Time.

Price Elasticity of Supply

-Relationship between costs and output;
- nature of the product.
- Time;
Time Difference “Short” (SR) and “Long” Run (LR)

Remains Abstract & Indefinite

Consumption
Short Run – Durable Purchases & Habits “constrain” choices
Long Run - More flexibility

Production Time to change Input/Factor Levels differs

Variable Inputs/Factors e.g. Labour
Fixed Inputs/Factors e.g. Land Capital

Short Run - Fixed Inputs fixed!

Long Run – All Inputs variable

Absolute Values Elasticities Long Run > Short Run?

Production health warning. Short Run & Long Run Implications

Underlying “Story” Upward Sloping

Firm’s Marginal Costs Market Supply Curve
Increasing Price
S0

Quantity

Credible Short Run - Capital Level fixed

Long Run Firm’s Marginal Costs always Increasing ?

Will return to this later – for moment assume cases LR and

SR supply curves upward sloping
Oil Market - Unique combination

Extremely High Volatility Price – OPEC Cartel

Importance of rest of economy , Role in Climate Change

How can Supply & Demand help explain oil price movements?

Alternative Models: Long Term Outlook

"World Oil: Market or Mayhem?" James Smith. 2009. Journal
of Economic Perspectives, 23(3): 145-64. DOI:10.1257/jep.23.3.145

Historical Price Series – Volatility – Long Run + Short Run

Annual Oil Price (2013 Values) WTI Closing Daily Oil Price 2006
$/b

EIA

BP Statistical Review 2014

Mon 7 August 2006

OPEC Oil +3% Price Increase
Iranian
Embargo
Revolution
Background
Oil Exports (crude oil plus refined products ) leading commodity
world trade 13% all trade by value 2006

30 Countries produce significant volumes

2/3 total production exported

Middle East, former Soviet Union, Europe, China , Japan and

traditionally US largest importer

Multiplicities of grade – highly integrated world market – price

differentials – desirability each grade.
Market Structure
Changed significantly over time
Pre 1970s 8 largest multinationals produces 89 % of oil

2009 –5 Companies (merged from 8) ExxonMobil ,BP, Shell,

Chevron, Total 12 % production 3% remaining oil reserves

Major producers – State-owned National Oil Companies of

exporting nations Control >50% production, 70% proven
reserves

Organization of the Petroleum Exporting Countries (OPEC)

most important producer organisation
Supply Chain Oil Producers to Refiners to Wholesale/Retail

Vertical Integration Significant. For 20 largest oil producers

refine 77% of their own production (Smith, 2009)

Range of Related Markets

Spot & Forward - physical cargos immediate/ future delivery.
Trades Oil Companies & Trading Companies Important
e.g. Brent Crude – World’s Largest Oil Market .
Trading Companies (Intermediaries) 5 out of 6 Transactions

Futures Markets – Trade “Paper” Barrels

Commercial Stocks (Inventories) – held by Companies produce,

refining & market oil.

Strategic Stocks - Governments

Organization of the Petroleum Exporting Countries (OPEC)
Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria,
Qatar, Saudi Arabia, UAE, Venezuela

Founded 1960. Aims

“to coordinate .. the petroleum policies of its Member Countries
and ensure the stabilization of oil markets in order to secure....
a steady income to producers and a fair return on capital for
those investing in the petroleum industry.”

Cartel – use market power to maintain prices

Restrict Overall Output
1) “Shutting In” Existing Production Capacity
2) Restricting new capacity growth

June 2014 - Official overall output quota 30 m barrels/day

. Proved Reserves -
deposits economically
exploitable current prices
and technology.

Smith(2009)
.
World Oil Supply (m barrels/day

OPEC 2011 2012 2013 2014

Crude 29.2 29.9 31.3 30.4

NGLs 5.6 5.9 6.3 6.4

Total OPEC 34.7 35.8 37.6 36.8

% World Supply 39.7 40.4 41.3 40.2

Total Supply 87.4 88.7 91 91.6

IEA ‐ Monthly Oil Market Report Jan 2014 Tables
http://www.iea.org/oilmarketreport/tables/
 Price
.
Model International Oil Market
OPEC plus Competitive “Fringe”
Supply

Pe

Demand

Quantity
Qe
Consider – Impacts
Demand and Supply “Shocks” (Short Run & Long Run)
Oil Supply Function
Short Run - very inelastic - fixed reserves and production.

Long Run - slightly more elastic. Higher prices induce new

exploration and field development.

Smith(2009) reports
Short Run estimate 0.04
1% Oil price Increase → 0.04% Quantity Supplied Increase

Long Run estimate 0.35

1% Oil price Increase → 0.35% Quantity Supplied Increase
Oil Demand Function

Short Run - very inelastic . technological choices limit

adjustment potential, e.g. Cars etc.

Long Run - less inelastic. Higher prices change durable

consumer purchases

Smith(2009) reports

Short Run estimate -0.05

1% Oil price Increase → 0.05% Quantity demanded Decrease

Long Run estimate -0.3

1% Oil price Increase → 0.3% Quantity demanded decrease
Long Run – Other “Adjustments” Possible

e.g. Higher Oil Prices “Induces” Technical Change

Supply Side e.g. New drilling technology.

→ Supply Curve Shifts

Demand Side e.g. energy efficiency improvements.

→ Demand Curve Shifts
"World Oil: Market or Mayhem?" James Smith. 2009. Journal
of Economic Perspectives, 23(3): 145-64. DOI:10.1257/jep.23.3.145

Annual Oil Price (2013 Values)

BP Statistical Review 2014

OPEC Oil
Iranian
Embargo
Revolution
 Iranian Revolution 1978 Oil Supply disruption -6 m
barrels/day OPEC refused increase quotas other members –
Treat like Supply Shock

Price
S1

S0
Short Run Supply & Demand
Very Inelastic
Large Price Effect
Pe1

Pe0

Demand
Qe1 Qe0 Quantity
 Iranian Revolution 1978 Supply Shock
Oil traders anticipating future higher prices – Increase
Inventories Demand – Induced Demand Shock
Price
S1

S0
Short Run Supply & Demand
Very Inelastic
Pe1 Large Price Effect

Induced Demand Shock –

Pe0 Increases Price Increase

D1
D0
Qe1 Qe0 Quantity
 Iranian Revolution 1978 Impact Long Run
Long Run Supply & Demand Less Inelastic
Smaller LR Price Effect
Price

S1

S0

Pe1
Pe0

Demand
Qe1 Qe0 Quantity
Estimated Shifts in Supply and Demand (Holding Price
Constant)

Non OPEC Production

Demand

OPEC Production

Smith (2009) Figure 3

World Oil : Markets or Mayhem? James Smith JEP 2009

WTI Closing Daily Oil Price 2006 $/b

EIA

6 August
BP Announce 400 thousand
Immediate Trans- barrels/day of Mon 7 August +3%
Alaska Pipeline total world supply Increase in Price
Closure 0.47%
 Supply Shock – Unexpected Reduction in Production
Out Of Equilibrium Q demanded > Q supply
Need Price Rise - Qd fall, Qs increase.
3% Rise Consistent with D&S theory prediction ?

Price Elasticity of Supply Price Elasticity of Demand

% Qs % Qd
es ed =
% P % P
es % P % Qs ed % P % Qd

Total %Quantity Change= %Supply Increase + %Demand Reduction

% Q es % P ed % P
Total %Quantity Change= %Supply Increase + %Demand Reduction

% Q es % P ed % P
% Q
Predicted % P
Price Change es ed
Trans-Alaska Pipeline Closure 0.47% World Production
0.47
es =0.04, ed 0.05 % P 5.2%
0.09
Predicted Actual Increase larger than 3%
“All Other things being Equal?”
US Government announced potential use Strategic Reserves

Conclusion – Price Spikes consistent with Small Shocks +

inelastic demand & supplies
Summary

Price Determination

Basic D&S Analysis: Subsidies and Taxes

Price Elasticities of Supply and Demand

Short versus Long Run

D&S and Oil Price Volatility

.