ECON 203 Term Paper

The global oil investors are coming to the realisation that the largest risk to the price of oil is more likely to be the demand being higher than the supply, rather than other factors like unwanted crude overhang. Brent crude oil price has reached $52 per barrel, which is double price for January’s lows of nearly 13 years, and the driving factor has primarily been a reduction in global production which has happened fast enough to cause supply and demand to be aligned quickly than had previously been anticipated (The Economic Times,2016). Over the last year, close to one million barrel a day have disappeared from U.S production that is of a high cost, a key factor that has contributed to the surplus that resulted to the build-up since the voting in late 2014 by Organisation of the Petroleum Exporting Countries. The voting was done for the purpose of sacrificing price strength for share of the market. In addition, unplanned outages resulting high incidences of Canada’s wildfires, economic and political upheavals in Libya and Venezuela that have taken as much as $ 4 million bpd offline in the month of May has resulted to the decline in production (The Economic Times,2016).

The law of demand and supply has the primary effect on the oil industry since it determines the global oil prices. Demand and supply is probably the fundamental theory of economics and is the basis of any market. Demand means the quantity of a certain commodity that the consumers desire. The quantity demanded refers to the amount of a product that consumers are willing to purchase. Quantity supplied is the amount of that commodity which is supplied by the suppliers at a specific price. There is close relationship between the quantity of a certain product that is supplied and, how much of that product is demanded by the consumer and the price of that product (Hirschey, 2009). The price of oil in the global market has been reducing considerably, due to the economic recession that was experienced since the year 2007. However, the above mentioned factors have have seen a reduction in oil production in the mentioned countries. This has had a big impact in the prices in the global oil market where demand for the product is growing though slightly but uncertainty exist about the continuity of supply in the market(The Economic Times, 2016). Over the past two years, volatility, which measures the cost of owning a certain option has reached its highest point on options that are very near-term and deeply unprofitable or those options whose owners have the right rather than obligation to sell oil at a particular price by a given date. This has seen focus shifting to unprofitable put options that have a maturity period of almost a year. This kind of switch would mean that investors have more confidence with a prospect of a higher sustainability in the price of oil and a lot of the concerns about the extent of the crude oil in storage tanks or on ships that represent an unwanted overhang may have evaporated. Everything on this oil market begins and ends with the consideration of whether the supply or demand is excess. If there is an excess in demand, many of the factors that moving time structure and volatility – risk of inventory storage running out or being full to capacity – disappear. There is still economic growth especially in the emerging Asia which means that there will remain a solid oil demand there. This will bring about a balance in the oil market over second half of current year, which can explain possible increase of prices (The Economic Times, 2016).

These changes in the oil supply will lead to the price remaining constant or increasing since the demand will keep growing as the global economy is growing. Both the supply and demand of oil remain moderately inelastic over the short-run. The drilling of more oil in the producing countries to bring more supply online may take time meaning the prices will continue increasing. In the short run demand for this product remain inelastic because there are no substitutes to oil as source of energy. The supply will also remain inelastic in the short run since there will be no more production in those countries that are experiencing economic and political disturbances. This inelasticity in oil supply means that there will be even a higher percentage increase in the price than in the overall demand of the same product (Kroon, 2007). When the prices are high, political and economic situations in those countries becomes better, the producers may increase their level of production since the marginal cost will be high. However, in the current scenario where there is disruption in supply, the production will remain low because of factors that are beyond the control of the producing countries.

In an equilibrium graph, the resulting disruption in supply makes the supply curve for this product to shift to the left which causes the price to increase. As stated earlier, the increasing demand due to growth in the developing countries especially in Asia will influence largely the demand and supply of oil. As these countries become more industrialised so that oil demand remain constant and oil production reduces, the demand curve shift to the right.

                          Increase in Oil Demand

 Increase in the demand of oil makes the demand curve to shift to the right.

 

                                            Supply

 

 

 

     Price                                                                    New price equilibrium      

 

 

                                                 Demand

 

                         Quantity

 

In the above figure the, the rise in the oil demand has as similar effect to the decrease in supply , thus the price of oil will respond considerably to a rise in demand.  Due to reduction in the production of oil, the prices increased to a high of $52 per barrel. The equilibrium occurs where demand curve and supply curve intersect which is an indication of no allocative efficiency. In the real market, however, the achievement of equilibrium can only be in theory, hence the price of a product is changing constantly in relation to the fluctuating demand and supply (Hirschey, 2009).  

Conclusion and recommendation

The increase in the price of oil may be good news to the markets that rely on it for economic sustainability. However, further increase may result to negative effects on the economies that rely on crude oil as the main source of energy since it may result to high cost of production and thus high cost living . The political and economic disturbances should that be arrested so as to keep the production level at the acceptable level. This will stabilise both the economies that depend on oil as a main source of income and the ones that utilise oil as a source of energy.

 

 

References

The Economic Times (2016). The latest oil bet: From too much to too little.1. Retrieved from: http://articles.economictimes.indiatimes.com/2016-06-09/news/73665748_1_brent-crude-supply-and-demand-hans-van-cleef

Hirschey, M. (2009). Fundamentals of managerial economics. Mason, OH: South-Western/Cengage Learning.131

Kroon, G. E. (2007). Barron's macroeconomics the easy way. Hauppauge, N.Y: Barron's Educational Series, Inc.