Saturday, December 13, 2008

Oil Prices (1)

Back in July 2008, the price of oil peaked at nearly $150 a barrel. By November the price had dropped under $50. This is an amazing change in prices over a short period.

The usual pattern for most goods and services is that prices rise and fall to clear the market. If demand increases, the prices rise and supply increases to meet the new demand. If demand declines, the price will fall slightly, causing the supply to fall.

If either the supply or demand for a good does not respond quickly to small changes in price, bigger price changes may be needed to clear the market. This is the situation with oil. (Economists describe this as inelasticity with respect to price, but you can forget that if you are not an economist).

The reason for the recent sharp fluctuation in the price of oil is that production does not respond quickly to changes in price. Prospecting for oil is a hit and miss affair that takes time. Bringing a new oil field into production takes several years. When there is no spare capacity, an increase in price does not lead to increased production, because producers cannot bring new fields into production quickly.

The other reason is that most of the large oil fields in the world are owned by government authorities. Politicians do not like reducing their spending. So when prices fall, state-controlled oil companies do not cut production, because the politicians do not want to reduce their spending.

This problem has been evident over the last few months. OPEC agrees that the logical response to the falling price of oil would be to cut production to maintain the price at least $80, but they have been unable to take action, because none of the OPEC member states are willing to cut production. The politicians avoid economically sensible actions, because they have a short-term focus that makes them unwilling to think further ahead than the next election, or the next coup.

The complexity of the production process and the complicity of the political process prevents oil production from responding quickly to changes in price. This means that changes in demand can produce sharp fluctuations in price.


Gene said...

You do know that cartels almost NEVER work.

Oh, for a very very short time there will be some effect. But in the end. NO

Ron McK said...

You are missing the point. This has nothing to do with cartels.

When the price of a good falls dramatically, all producers have to decide how to respond. If the good is not perishable, most clear-thinking producers would reduce production and wait to they could get a better price. Governemnt producers are unwilling to do that that, because they think short term and they love to spend.

Producers have to make these decisions, whether they are in OPEC or not. I only used OPEC as an example, because they "sort of" make their production decisions public.