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.
- Gas Prices Surge Again and Renew Talk of a Double-Dip Recession (dailyfinance.com)
- Oil spike likely to cut EIA oil demand forecast (reuters.com)