Double Dip?

Anyone who has a car knows what’s happening to oil prices. This week, it became common in many parts of the United States to see gasoline prices in excess of $4 per gallon. This increase is based on the increase in oil prices; West Texas Intermediate crude broke $100 per barrel last week, and continues to rise. But why is the price of crude rising and, and why so quickly?

To understand the answer, it’s important to understand demand elasticity, that is, how sensitive demand is to changes in prices. Anyone who has had a class in basic economic theory has seen the traditional supply and demand “curves,” (straight lines in this example) as shown to the right. The red line represents the supply curve (as prices rise, businesses can spend more to supply more), while the blue line represents the demand curve (as prices rise, people will buy less). And where the two lines intersect is called the market equilibrium, the price and quantity to which the market naturally converges.

But let’s examine the slope of that demand curve based on the realities of the oil market. The United States consumes nearly three gallons of crude per person per day (so does Canada, by the way). The rest of the industrialized world consumes about half that, and the rest of the world a mere quarter gallon per person per day. In the United States, two-thirds of the oil consumed is used for transportation. But when gasoline prices go up at the pump, people don’t change their consumption by much. After all, how many people move closer to their jobs just because the price of a gallon of gas went up by 50 cents? Most people in the US can’t realistically take public transportation to work, and very few carpool.

And that’s just daily commutes. When it comes to air travel, people either travel for work, in which case they travel regardless of the price of the airline ticket (within reason), or they travel for pleasure, in which case they buy tickets far in advance. Plus, airlines set schedules well in advance for a host of different reasons. So any shift in the price of oil will take a long time to filter through the market and cause a shift in demand for jet fuel.

The list goes on. For any transportation use of fuel, I can demonstrate that demand shifts occur slowly, if at all. Over the long haul, demand may well drop, but it takes a while. Until it does, the demand curve looks much more like a vertical line, like you see to the left.

Contrary to what some people assert, supply doesn’t need to be cut in half, nor does demand have to double, for prices to double. That would only occur if the supply and demand curves looked exactly as they do in the first graph above. As you should now be aware, the demand curve certainly doesn’t. And neither does the supply curve.

Given that it looks more and more like we are at or near the peak production of crude oil, at least for the recent historical market prices of approximately $75 per barrel, the market is extremely sensitive to small impacts to supply. There isn’t enough slack capacity to make up for even small production decreases. Even though Libya represents only 2% of the current supply of oil, the lack of excess capacity means that shutting off 2% of the supply requires a corresponding drop in demand of close to 2%. With a demand curve as steep as we have, forcing a drop in demand of 2% requires substantial increases in price, at least in the short term. As behaviors change (people travel less, buy food grown shorter distances from home, exchange cars for more fuel-efficient models, etc.), the demand curve shifts to the left, easing the price pressure.

But something else can shift that demand curve to the left. We saw it in 2008, as you can see in the chart to the right.

What happened was the biggest recession since the 1930s. Obviously, with fewer goods being sold and more people out of work, the worldwide demand for transportation oil dropped significantly, and quickly. With the sudden shift of the demand curve to the left, the new equilibrium price returned to under $50 per barrel.

Here’s where the story gets interesting. The recession was triggered by the high fuel prices. They finally rose enough that people started to change their behavior and buy less, because those fuel prices started to be noticeably reflected in retail prices of all sorts of goods and services. Coupled with the kindling of a housing bubble, the economy had a long way to fall.

The economy has been improving in little fits and starts since the spring of 2009. But it is still a long way from a truly healthy economy. This week, the International Energy Agency announced that they predict a drop in oil demand, due to expecting a second recession caused by the sudden price increase. Coupled with what looks to be significant cuts in federal government safety net spending, we may be in for a very rough year.


About Michael Weiss

Michael is now located at http://www.logarchism.com, along with Monotreme, filistro, and dcpetterson. Please make note of the new location.
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24 Responses to Double Dip?

  1. Monotreme says:

    If only.

    If only we had used the many earlier opportunities we had (going back, in my reckoning, to the Carter Administration) to get a handle on our national energy policy.

    Still, the way forward is a carbon tax (my preference), or cap-and-trade, or at the very least a rational discussion as exemplified here.

  2. mclever says:

    Aren’t oil prices falling today?

    Not that I dispute any of the mechanics in this article, and especially not the “call to arms” to do something permanent about our unending appetite for fossil fuels.

    Just that oil prices are wobbling, so maybe we won’t get such a severe double-dip. (Yes, I’m an eternal optimist. I’ve learned from filistro.)

  3. Carbon tax is useful against CO2 increases, but if the only goal is to get off of foreign energy dependence, a stiff import duty on oil would work pretty well, too. Of course, that would make more than a few people very unhappy.

    I rather like the idea of a petroleum tax with the proceeds going specifically to renewable energy R&D and subsidies, with the subsidies tied to a sliding scale of adoption. The US has a phenomenal amount of geothermal energy available. Converting to more use of geo-to-electricity and electricity usage for transportation would do wonders for energy independence.

  4. Aren’t oil prices falling today?

    The change in prices isn’t necessarily signal. When there’s a significant force that changes the shape of the market, prices tend to overshoot the equilibrium point, and then oscillate around it, converging toward it. Of course, additional forces may prevent it from having a chance to settle at that new point. For example, Qadhafi bombing one of the more significant oil facilities in the country.

  5. Monotreme says:

    Michael,

    Yes, I should have said that. The carbon tax would be used to subsidize non-carbon sources of energy: nuclear, geothermal, wind, solar, and so forth.

    Any future energy policy I can imagine involves a mix of available technologies. For example, oil (either from fossil fuels or biodiesel) will always be in the equation for chemical engineering and airplanes, just to pick two obvious examples.

  6. Mr. Universe says:

    Carbon tax is the crux of my thesis. It’s deigned to promote sustainability in supply chain mgt.

  7. Monotreme says:

    Deigned or designed?

    (I know the answer, I’m just teasing. Maybe it’s a Freudian slip?)

    😉

  8. rgbact says:

    1) Print money, causing increase in commodity prices, including oil-check
    2) Put moratorium on off shore drilling-check
    3) Ban drilling in largest US oil field, ANWR-check
    4) Wring hands over what to do about oil prices and peak oil -check

    Congrats on the manufactured crises.

  9. Monotreme says:

    rgbact says:

    1) Print money, causing increase in commodity prices, including oil-check
    2) Put moratorium on off shore drilling-check
    3) Ban drilling in largest US oil field, ANWR-check
    4) Wring hands over what to do about oil prices and peak oil -check

    I don’t see any of your numbered points in the above post or comments, except possibly #4 and that’s a stretch.

    Please do tell us all what it is you’re going on about.

  10. rgbact,
    Just so you know, you’re stepping into dangerous territory. Based on your past comments, I suspect you’re in way over your head here. But, that said…

    Print money, causing increase in commodity prices

    Who’s doing this? What’s the mechanism by which it is happening? What’s the evidence that this money printing is happening?

    2) Put moratorium on off shore drilling-check
    3) Ban drilling in largest US oil field, ANWR-check

    And let’s assume that every possible drop of domestic oil were being pulled out by pumps as we speak. Looking at the big picture, how would this have addressed the issue of peak oil?

  11. Monotreme says:

    I don’t think much of the simple minded “divide gas prices by income” metric, but it’s interesting to see these maps nonetheless.

    http://money.cnn.com/2011/03/09/news/economy/gas_prices_mississippi/index.htm?hpt=C2

  12. mclever says:

    Wait, there’s public transportation in California?? 😉

    The gas prices/income map is a little simplistic, but the point does hold that rising prices hit rural folks the hardest, because they have the longest commutes with absolutely no options except driving. At least in more heavily populated areas, there are options to arrange carpools with one’s neighbor, to take the bus, or even to walk in some urban neighborhoods.

    I think the income comparison is definitely oversimplified for a variety of reasons. First of all, there was no mention of adjusting based on the COLI (with fuel prices excluded), to account for variations in other basic living expenses. Also, the presence of a pocket of rich suburbs or a community of, say, Hollywood Millionaires or other celeb/execs can significantly skew the average. I wouldn’t think that downstate Illinois or rural Nevada is any better off than major portions of Mississippi, but treating the states as averages makes states like Illinois and Nevada look like they’ll be just fine with high gas prices. Parts of those states (nearest the major cities) probably will be OK, but there’s a large swath of land that isn’t within the reach of the Metro trains…

  13. Mr. Universe says:

    Maybe it’s a Freudian slip?

    Keyboardian slip. But a good one.

  14. msgkings says:

    Rising energy costs, which will not stop until a whole new cost-effective supply comes about, will most definitely continue to fall hardest on the rural and thus continue the accelerating urbanization of our world.

    Seems counterintuitive, but Manhattanites are more green living than those who live in the ‘green’ parts of the country, the burbs and the farms.

    And rgbact, your post above dropped your credibility a long way. Can’t you understand that even though the posters here mainly disagree with your politics, they are smart people? If you are too, you can’t possibly believe that ANWR and a few month offshore drilling moratorium have anything to do with the globally set price of oil, can you?

    The Fed is another thing…no question the liquidity our central bank (and others) have been adding to the system has fueled some of the rise in oil, stocks, etc. But even you’re smart enough to know that’s also not the whole story. Right?

  15. Max aka Birdpilot says:

    msg,

    Do you actually expect an answer from rgbact? Of course, after last weekend his cred was so close to ZERO that it’s hard for it to drop much further.

    Bless his heart. I can see him now in front of the computer:

    Eyes clinched tightly shut, earplugs in with Bose noise canceling headphones on just to be sure, mouthing GOP talking points as he types, thinking: “I saw it on Breitbart, I need no more justification!”

  16. rgbact says:

    MW–

    Just read the posting guidelines. I didn’t realize this forum had moved more liberal than 538. It seems conservative leaning posts are subject to a strict quality review process. Well that doesn’t sound fun- but I visit conservative only sites so I can respect it. I doubt this will achieve your suppposed goal of having more conservatives contribute, but best of luck. Regards.

  17. It seems conservative leaning posts are subject to a strict quality review process.

    Not at all. I fully expect liberals to be held to that same standard.

    What I don’t want is either side of the aisle making assertions without being able to back it up with some facts. Gator’s done it pretty well. So is Mule.

  18. Max aka Birdpilot says:

    rg,

    ALL posts here have pretty strict quality review.

    I have had to justify positions more than once.

    Don’t feel special because I reamed you a new one: MW, shortchain, shiloh, mono and others here have been on the receiving end of my challenges as well (fili, never, but then she strokes ones ego so well it’s hard to give her grief). The difference is that we respond to those challenges, making our best arguments for our case, with multiple comments, at times going for hours and even a day or more. We don’t hide and cower behind some self delusional paranoia, or claim to be gnostic because of ideology. It’s a kind of peer review. (Something of which it seems you have no knowledge) We don’t always agree, but, when one makes a good case, we CAN agree to disagree.

    Go cry a river somewhere else, unless you can grow up to the point that you can stand INSIDE the fire.

  19. filistro says:

    @rgb… It seems conservative leaning posts are subject to a strict quality review process.

    Nobody objects to somebody posting an opinion… even an unsubstantiated or outrageous one… as long as they preface it with something like , “I think…” or …”Of course this is just my opinion….”

    You don’t need a whole ream of facts and data at your fingertips to make a point at this blog… unless you’re calling that point a FACT… in which case you have to be prepared to back up your claim.

    This was the problem we had with a few other posters in the past. They made lots of claims with great authority, but consistently refused to back up their statements with facts when challenged… just faded away for a while and then resurfaced with new claims, similarly unsubstantiated.

    Nobody, liberal or conservative, should present opinion as fact and expect not to be challenged to provide proof.

  20. Not necessarily proof. Supporting evidence is at least enough to converse about.

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