1. China has become the world’s second largest energy consuming country after United States of America. Flourishing economic countries like India and China are becoming huge oil consumers.

On the other hand, the rise of hydraulic fracking from Montana to Texas to Pennsylvania has lifted U.S. oil production mightily, from 5.6 million barrels a day in 2010, to a current rate of 9.3 million.

Discuss the above mentioned factors and their likely importance in determining oil prices in the world.  [25m]

 

Introduction

The amount of a good in the market is the supply and the amount people want to buy is the demand. If there is a strong demand for oil, but there is less gasoline, then the price goes up. If conditions change and there is a smaller demand for oil, due to the presence of more electric cars for instance, then the price of the commodity decreases. In the above preamble, it is stated that the demand is increasing due to emerging economies like China. On the other hand,the supply has increased as well due to new technology. In this essay, we shall examine the above mentioned factors and their likely importance in determining oil prices in the world.

Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers (at current price) will equal the quantity supplied by producers (at current price). This results in an economic equilibrium of price and quantity.

In the above preamble where there is an increase in demand for oil, it is likely to lead to an increase in the price of oil. This is caused by a rightward shift in the demand curve.

Diagram.

However there are other determinants of demand as we shall examine below.

Changing prices of a substitute good

  • Substitutes are goods in competitive demand and act as replacements for another product
  • For example, a rise in the price of Esso petrol should cause a substitution effect away from Esso towards competing brands such as Shell.

Changing price of a complement

Two complements are in joint demand – e.g. cars and oil

  • A rise in the price of a complement to Good X should cause a fall in demand for X. For example an increase in the cost of bread would cause a decrease in the demand for butter.
  • A fall in the price of a complement to Good Y should cause an increase in demand for Good Y. For example a reduction in the price of the new iPhone should lead to an expansion in demand for the iPhone and a complementary increase in demand for download applications.

Changes in the income of consumers

  • Most of the things we buy are normal goods. When income goes up, our ability to purchase goods and services increases, and this causes an outward shift in the demand curve. But when incomes fall there will be a decrease in the demand, except for inferior goods.
  • Discretionary income is disposable income less essential payments like electricity & gas and mortgage repayments. An increase in interest rates often means an increase in monthly mortgage payments reducing demand. In recent years we have seen a sharp rise in the cost of utility bills with a series of hikes in the prices of gas and electricity. This has eaten into the discretionary incomes of millions of households across Singaporeans.

The effects of advertising and marketing: Heavy spending on advertising and marketing can help to bring about changes in consumer tastes and fashions. For e.g. private transport versus public transport.

Interest rates and demand

  • Many products are bought on credit using borrowed money, thus the demand for them may be sensitive to the rate of interest charged by the lender. Therefore if the Federal Reserves decides to alter interest rates – the demand for many goods and services may change.
  • Examples of “interest sensitive” products include cars and especially the demand for housing which is affected by changes in mortgage interest rates.

Price Elasticity of Demand

Price elasticity of demand PED measures the responsiveness of a percentage change in the price of oil to percentage change in the quantity demanded of oil. The PED of oil is likely to be inelastic as there are no major substitutes yet. However in certain countries where public transport is more common that private transport, it is likely that the PED might be more elastic and hence price of oil will not rise as much.

 

Supply is defined as the quantity of a product that a producer is willing and able to supply onto the market at a given price in a given time period. In the preamble, it is mentioned that supply has increased due to new technology in fracking. Hence we can conclude that the supply curve will shift to the right.

Diagram.

However, we will also see in below paragraphs that there are other determinants of supply.

 

Changes in the costs of production

Lower costs of production mean that a business can supply more at each price.  For example a magazine publishing company might see a reduction in the cost of its imported paper and inks. A car manufacturer might benefit from a stronger exchange rate because the cost of components and new technology bought from overseas becomes lower. These cost savings can then be passed through the supply chain to wholesalers and retailers and may result in lower market prices for consumers.

Conversely, if the costs of production increase, for example following a rise in the price of raw materials or a firm having to pay higher wages to its workers, then businesses cannot supply as much at the same price and this will cause an inward shift of the supply curve. This is the case for fracking as it is more costly than traditional methods of oil production.

fall in the exchange rate causes an increase in the prices of imported components and raw materials and will (other factors remaining constant) lead to a decrease in supply in a number of different markets and industries. For example if the Sing Dollar falls by 10% against the USD, then it becomes more expensive for travelling to USA or importing products from USA.

 

Government taxes and subsidies

Government taxes and subsidies

Government taxes and subsidies

Changes in climate

For commodities such as oil, the effect of climatic conditions can exert a great influence on market supply. Favourable weather will produce a bumper production and will increase supply. Unfavourable weather conditions will lead to a poorer production, lower yields and therefore a decrease in supply.

Change in the prices of a substitute in production

A substitute in production is a product that could have been produced using the same resources.  Take the example of barley. An increase in the price of wheat makes wheat growing more financially attractive. The profit motive may cause farmers to grow more wheat rather than barley.

The number of producers in the market and their objectives

The number of sellers (businesses) in an industry affects market supply. When new businesses enter a market, supply increases causing downward pressure on price.

Competitive Supply

Goods and services in competitive supply are alternative products that a business could make with its factor resources of land, labour and capital.  For example a farmer can plant potatoes or maize.

Simultaneous change in demand and supply will also affect the price of oil. For e.g. if the demand increases more than supply, price will rise. However if the supply increases more than demand, the price will fall.

In conclusion,

  • We tend to use supply and demand diagrams to illustrate movements in market prices and quantities. The factors mentioned in the preamble are important in determining the prices of oil. However we have also seen that there are other factors to consider.
  • The reality in most markets and industries is more complex. For a start, many businesses have imperfect knowledge about their demand curves – they do not know precisely how consumer demand reacts to changes in price or the true level of demand at each and every price
  • Likewise, constructing accurate supply curves requires detailed information on production costs and these may not be readily available.