Jun 29 2008
Oil Crisis??
Perhaps I should have named the title of this post ‘Energy Crisis??’ instead. I want to touch on a few things in this essay. The supply and demand theory as explained in collage economics classes. The change in demand of oil , both crude and refined. The change of supply of oil. And finally the change in price. All of this will be followed by more posts about what the real problem might be, and possible solutions to those problems.
What drives the price in economics?
People like to save money. A shirt for ten dollars is more likely to attract a buyer than the same shirt at twenty dollars. More people are willing to spend ten dollars on a shirt than twenty. That is what is called the demand curve. The higher the price, the fewer people will buy an item. The price at which the seller is willing to supply the shirt is considered the supply curve.
The higher the price the more the supplier makes on each sale, so of course they want to sell more items. That is shown in the fact that the supply (blue) line is an upward arch to the right. However, the higher the price, the less the consumer wants to buy. That is why the demand (red) line is a downward arch to the right. In the picture you can see that if the price where P1 then the supplier would be happy to supply a quantity of Q1 of the items. Because the demand curve (the red line) meets the supply curve (the blue line) at that point, the consumer would also be happy to buy all of the items that the supplier is willing to produce at that price. Using this model, if the supplier raised the price, then the consumer would by less of the item, not more. The only way for the supplier to make more money per item and still sell the same amount of items or more is if the demand shifts. More demand means that the supplier can get more money per each item. So to answer the question “What drives the price in economics?” It could be said that it is driven by demand, right? Well, mostly right.
Because almost everything has an alternative, if someone doesn’t like the price, they go buy something else that will satisfy the need they are having. But not everything has an alternative. A person can go find another shirt at a different store, but if that person needs a specific medicine for a specific disease, and only one drug company makes it, that person either buys it at the price the drug company sets, or goes without. Now if the drug is needed to stay alive the person is choosing between paying a price that they think is exorbitant or not to pay the price and die instead. Most people choose to pay, no matter what the cost. In that scenario, the supplier sets the price, not the demand. Also, note that can only happen if there is no other alternative solution.
To sum things up, in an open market (many suppliers with the same type of product) where there are alternatives to goods, the consumer sets the price. In a closed market (only one supplier with the good needed) where there are no alternatives means that the supplier sets the price. The best market for the general population is an open market. The best market for money hungry corporations is a closed market.
The Crude Oil and Energy Market
Lets find out what kind of market the Crude Oil companies are in. First lets look at the demand in the market. in 1999 when a gallon of gasoline was an average of $1.58 nationally, the US consumed 19, 520,000 barrels per day of crude oil. In 2007, 8 years later, the US demand had shifted to 20,730,000 barrels per day. This represents a 6% change in demand. The price is a different story however. In 1999 it was $1.58 average nationally. In June of 2007 the average price was on a decline from previous months at roughly $3.00 per gallon (all prices are for regular unless otherwise noted). This represents an 89.8% increase in price. In June of 2008 the price reached over $4 per gallon at the pump. That represents a price increase of 33.3% from 2007. Was there more demand for more oil that caused this increase? No, the demand has fallen some (reference needed) in the face of the higher prices.
This can mean only one thing about the crude oil market. It is closed. The people have to have it and there is only one supplier. Even though alternatives exist, they are not offered to the people that need them. So the US is a nation that is dependent on oil, and like monopoly, those that control the price of oil will continue to raise the price until the people cannot support the price anymore and decide to go without. That is how a closed market works. Pay the price or go without.
This may come as a shock to some, but the price of oil is not set directly by those that supply it. It is a commodity. Commodities prices are set by the perceived value and scarcity of the product by those that trade in the right to sell the commodity at certain prices. These trades are made in speculation on what the price of the good MIGHT do in the future. So a person thinks that oil will only continue to rise in price, so they place a contract to buy oil from a supplier at $140 per barrel for 10,000 barrels in two weeks time. That means that on the end of that contract that person could receive shipment of 10,000 barrels of oil and he would have to pay the supplier $1,400,000. However it other people think that oil will be worth more, they might start making contracts at $145 per barrel. So, on the day that the contract is executed for our person at $140, the price for new contracts is $145 per barrel. This would mean that that person could sell the contract for $145 per barrel (that is the going price) at at total of $1,450,000. That would mean that the trader made $50,000 just by speculating that oil prices will rise in the future. This can be a circle. One person thinks it will go up, so other think so too, so the price does go up simply because traders think it will. Then because it went up once, people think it is more likely to go up, so their renewed confidence in it will force it up again. And so on and so on. This is the world of commodity trading.
Does that mean that the people who use the product have no say. They do. If the product is not being retailed, then the people who really need the product will not by the speculators contracts for delivery. At some point the product must be delivered, or the contract is void. In the case of oil, the people HAVE to have it, so that means that they will pay what ever for it. So the refineries will continue to buy oil contracts no matter what the price. They just pass the extra costs on to the people who buy the gas or diesel.
So now it is plain to see that the price is set by one source, the commodity trading market. That translates into “we don’t care what happens to the people, just make money” from the speculators that are trading the oil commodity. This shows that commodity demand can make an impact on the price of oil. What happens if people think that the price will go up, and an oil company says “I will make a contract to sell 100,000,000 barrels at $5 below current market value. What would then happen to the market value? It would drop $5. Everyone would want that new price. This would only happen if there is an excess of oil not being delivered to refineries though. If you can’t sell your oil for market prices, then sell it cheaper. But if the companies decide that they will not pump enough oil to exceed demands, then there never is an excess. So the prices just soar with speculation. That is the situation the world is in right now. There is usually an answer for that problem. If oil companies are making lots of profit, then new oil companies should be able to start and make lots of profit too. Until there are so many companies trying to sell oil that not all of them can sell their oil. Then there is an excess and the price drops. The only problem is that the oil market is next to impossible to get into. New pumps just can’t be installed anywhere by anyone. Even it a person had unlimited funds, all the land that houses oil is already owned by other oil companies. So new startups can’t happen. It is a closed market. But it doesn’t have to be.