Sunday, November 11, 2007

Economics 101 - Demand & Supply of Crude Oil

Experts say that the current oil price 'crisis' is a lot different from the other two which hit the world during 1970s and 1980s. The earlier crisis were result of formation of OPEC and Iran Iraq war which disrupted the supply and hence by the law of economics at a constant demand if supply decreases then the price increases.

In the current scenario, when there is no obvious supply crisis, experts claim that the price is increasing as a result of increasing demand. especially from China and India who are in-efficient users of oil (use more oil per $ of GDP) vis a vis US and other developed countries. These economies growing at roughly 10% a year use 3 times as much oil per $ of GDP as some of the developed countries use. In the light of this data it would be interesting to see this exhibit:

The world is at the crossroads today where the developing world GDP is almost equal to developed world. Assuming that developing world uses 3 times more oil than developed world for every $ of incremental GDP, so the current oil demand should increase by 17% (assuming the developed world grow at 4% while developing at 10% with constant oil efficiency). In a scenario of linear supply function, the price should hence increase by 17% but in reality it has jumped by more than 60% in last one year.

Clearly it is not just the demand which is at play here. What can be the plausible cause to explain the price rise?
  • The supply may not be a linear function! The oil producers may be running very close to their existing operating limits and any significant increase in production will require huge investments and that too in geo-politically unstable regions.
This hypothesis may be partly correct in the intermediate to long term but looking at the short term it still does not make sense. The exhibit (from OPEC website) shows the OPEC capacity and in short term situation seems quite comfortable.

Another hypothesis can be increased geo-political risk premium. In the current world political environment in which nothing other than the US presidential elections seems to cause a major change in world order. Does this elections has anything to do with oil prices? May be... It would be interesting to listen to some of the conspiracy theorist for the Texas connection to this oil price increase! After all the invisible hand is also the part of demand and supply relationship!

To me, the situation seems to be a combination of these scenarios, the cause of the rise in oil price would be due to demand effect + premium for new investment + increased geo-political risk premium. about $15 (20%) largely due to China and India, and rest $25 as investment and risk premium.

If someone is worried about next generation seeing oil. Here is the good news. We still seem to have oil for thousands of years! The current demand is less than 100 million barrels a year while proven reserves are in excess of 1000 billion barrels. Though majority in regions of the world which may not be exactly peaceful to likening of our democratic uncle Sam.


Sandith said...

With reference to the last para, I thought the world consumption was around 100 million barrels per day and at that rate oil will last 13,000 days, ie. 35 years. Even Saudi reserves will last under 75 yrs at this rate. Please clarify.

Abhishek said...

Yes. You are correct. The site I got this data from said daily consumption as annual. But it also needs to be ascertained that the crude reserves is function of crude price. The available reserves increases tremendously if the price of crude increases as lot of crude reserves in high cost situations like deep in the sea bed, less pure crude etc becomes economically viable.

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Tuhin said...

Hi Abhishek,

It is really a nice article I came across. I do have question to you, by the sentence "The world is at the crossroads today where the developing world GDP is almost equal to developed world", you mean to say the purchasing power of GDP or accumulated GDP.
Kindly advice.

Abhishek said...

@Tuhin : Its aggregated GDP of the two blocks of the world. On absolute basis and not adjusted for PPP

Tuhin said...

Dear @Abhishek, Sorry for being late in checking,
By the way, can you please elaborate how you have divided the world into two blocks? I mean to say on what ground. I did check the following statistics ["2011 Economic Statistics, Economic Indicators Database for year 2011"] and according that it will take another 8-10 years for developing world to match the GDP with developed world.

Please explain.