Some thoughts on the Price of Oil — Part 1

One of the main questions occupying the public mind appears to be related to the price of oil. Since economics informs that, and related questions, I think it would be appropriate to reason economically (so to speak) about the matter. Will the unprecedented high price of oil become a permanent feature of the world or is it just a passing phenomenon, a bubble that is bound to burst? What’s the appropriate price of oil? Is the high price of oil a good thing, and if so, for whom?

As this is just a blog post and not a deep analysis meant for a peer-reviewed journal, I will be informal. That CYA disclaimer out of the way, let’s begin at the beginning.

What’s Oil?

A few fun facts about oil, in no particular order. It’s something that is (1) a non-renewable natural resource, (2) resource whose finiteness is acknowledged and known to a fair degree of accuracy, (3) geographically distributed only to a few areas, (4) non-perishable and can be stored costlessly for later extraction, (5) absolutely superior to any other source of energy in a wide range of applications such as aviation and personal ground transportation, (6) cheap to extract.

Now let’s do some informal modeling. Modeling is basically economics jargon for telling a simple story about a complex real-world phenomenon. It reveals the plot line without going into too many distracting details.

A digression: The Market for Lettuce

Imagine that you had something that you could trade. Every year a very large quantity (much larger than what the world can reasonably consume) of iceberg lettuce simply appeared in your backyard. All you had to do was pick some and sell them to the grocery store. What price would you charge the store? Depends on the demand for lettuce. Since you are the only supplier, you will of course do what a monopolist does: charge a price which would maximize your profits. This means that the quantity you deliver to the store is less than the quantity in your backyard.

Lettuce is perishable. You cannot store it for later sale. Moreover, in our model, it is renewable. Every period, a new crop of lettuce shows up for you to pick and deliver to the store. You are happy as a lark at your good fortune. Not only does the lettuce appear magically, but you are the only one who gets this bounty. You make handsome economic profits (also called “rents”).

But unfortunately for you, suddenly a bunch of your neighbors also start getting a crop of lettuce in their backyard. Now you can no longer control the supply. The store now has alternate suppliers. What do you do? Well, to cut a long story short, you lose your market power. You sell whatever you can at a price that just allows you to cover your costs of picking and delivering the lettuce to the store. The same with your neighbors. While you and the other suppliers bemoan this over your beers, the consumers are happy. They get all the lettuce they want at a price that is much better than the monopoly price. They are enjoying the “competitive market” price of lettuce.

Now let’s change the story a bit. Instead of an unlimited bounty of lettuce, you and your neighbors gets only a limited supply — some more and some less — but the aggregate supply is still sufficient to meet the demand for lettuce at the competitive market price. Nothing really changes: the price remains before, and no supplier makes any economic profits.

Now change the aggregate quantity to be lower than the quantity demanded at the previous competitive price. Then the price at the store will move up to equate the demand to the lower supply. Now the consumers lose and the suppliers gain. The suppliers are now making economic profits because the price is now above the costs of picking and transporting the lettuce to the market.

Now if you could increase the quantity that arrives magically in your backyard, you would do so. You could pray hard to the iceberg lettuce gods. So could your competitors. If only your prayers are heard, you are in luck. You make more profits because you supply more at the higher price. But if all your competitors prayers are heard as well, you are all back to square one: supply is plentiful enough that the price falls and your economic profits disappear. You just hope and pray that the iceberg lettuce gods are not moved by your competitors’ prayers, only your prayers. You want the aggregate supply to be lower — while your supply is higher — than the potential market demand.

Oil is not Lettuce

There is a limit to how much salads and burgers the world can consume. That places an upper limit to the demand for lettuce. The demand for oil is potentially unlimited because there are billions of people who would buy the sticky stuff for a variety of uses — from driving gas-guzzling SUVs to flying around in jet-planes to making manure to buying Chinese-made plastic crap. There is only so much oil in the ground. They are not making more oil every year and what you extract today leaves that much less for you to extract tomorrow. Since it is lying in the ground beneath your feet, you don’t have to worry about the cost of storing it.

We all know that lettuce is not oil. The point of discussing the market for lettuce from heaven was to put in stark relief the distinguishing features of oil, the most important of which is that it is exhaustible.

Pricing of exhaustible resources

Price is something that is determined through an interaction of supply and demand. The market-clearing or equilibrium price is that which equates the quantity supplied and the quantity demanded. Depending upon the conditions, you could have one equilibrium price or maybe multiple prices. A few years ago, the equilibrium price of crude oil was around US$20 a barrel; now it is around US$130 a barrel. Why and what does it imply?

In general, when the price of a commodity goes up, both the quantity supplied and the quantity demanded change. Suppliers respond to high prices by increasing the quantity supplied; consumers respond by lowering the quantity demanded. Which is another way of saying that high prices don’t persist unless there is a shift (a contraction) in supply and/or there is a shift (an expansion) in demand.

[Footnote: It is important to keep in mind the distinction between a shift in supply (or in demand) and a change in the quantity supplied (or demanded). A supply shift can occur due to a number of reasons: new technology, or newly discovered sources of supply, etc. A demand shift occurs when preferences change, or new uses and users, etc.]

So then, since the price of oil is so high, would that not mean that the quantity supplied would increase? Not necessarily. I think that if the price of oil is sufficiently high, it could actually reduce the quantity supplied. If you understand that point, — and you should understand it if you paid any attention to the lettuce story — you can stop reading this post. But if you wish to continue reading the post just to check my reasoning, please be my guest.

The nation of Crudistan, an oil-rich kingdom, has a large but finite supply of crude. It entire national income is derived from pumping out the oil and selling it in the world market. It needs $10 billion of income per year. Anything above $10 billion a year, it has to go buy US treasury bonds which give practically no returns; it is just a way of parking its money. So when oil is trading at $20 a barrel, it has to pump out 500 million barrels of oil a year and sell it. If oil prices slip to $10 a barrel, it has to pump a billion barrels a year just to meet its income goal. In short, in response to the lower price of oil, it has to increase its supplied quantity.

Conversely, if oil price climbs to $100 a barrel, Crudistan has to sell only 100 million barrels of oil a year to earn what it needs. If it continued to pump the 500 million barrels as before, (assuming that the additional supply did not reduce the price), its income would be $50 billion a year, and will have to park the extra $40 billion uselessly. It is better for Crudistan to reduce the quantity it sells today because it can therefore save the oil for later extraction and sale.

This is a perverse result. It appears to go against the normal behavior of suppliers in competitive markets.

So the bottom line. The high oil prices of today are a new equilibrium: very high prices, and low quantities supplied. As I have argued, there is a limit to how much income the oil suppliers have a need for. If that need is met at a lower quantity supplied, they will lower the quantity supplied. The lower quantity supplied, together with the increase in the demand, necessarily will push up the price — which helps to further reduce how much suppliers have to pump out of the ground.

Is there a limit to how high the prices can go? Yes, the price of alternatives. If say solar energy is available for $200 a barrel equivalent of oil, then the price of oil will stabilize at $200 a barrel.

In the next piece, I will go into the implications of this high price of oil, with particular emphasis on what it means for India and how should India react. Is it all doom and gloom? I don’t think so.

Related post: The Future of Energy. This is from September of 2005, and is one of my favorite posts.