Whither Oil Prices?

There has to be a serious decline in oil prices sometime in the near future. I just don't see how the economics support prices in the $70 range.

Here are just a few things to consider. Iran produces about 3.8 mbd (millions barrels per day).

China consumes about 7mbd.

The world produces and consumes about 85 mbd.

The price elasticity of demand for oil is at least .1, with the time horizon for this being not real short term but not real long term either -- say in the vicinity of one year. A shorter time period will give a smaller elasticity, a longer time period will give a higher one.

The spot price of crude on July 14, 2006 was $68. The spot price in July 04 was $34 -- that is a one hundred percent increase.

With the elasticity of demand at .1, that should give us a 10% reduction in demand for oil, or a decrease of 8.5 million barrels.

Now I grant that the price increase was somewhat gradual over this two year period, so we have not yet had the time for even this very small elasticity adjustment to take place. But it is, and it will continue.

A decrease of 8.5 million barrels is equivalent to taking out all of China's consumption. Or looked at another way, it is equivalent to losing all of Iran's production, plus Kuwait and Iraq as well.

And I have not even brought in the idea that there is also a small but positive price elasticity of supply. At $70, how much additional oil will it be profitable for all the world's producers to bring forth? Iran may bluster about cutting its oil exports, but at $70 per barrel, its marginal revenue for each additional barrel it produces is in the $40 range (a marginal revenue calculation based on a residual demand curve; see also my previous post on marginal revenue). The smaller the producer, the closer marginal revenue is to price. For producers of oil from the Alberta oil sands, you might as well take marginal revenue right now to be $70 per barrel.

The sad irony here is that it appears by threatening to cut supplies, some of the producing countries have managed to get prices high and they are probably taking advantage of those high prices by supplying even more! A good trick, but all good things have to come to an end.

One way to think about this market is that both the demand and supply curves are extremely steep. There is then a range of prices that are "almost" equilibrium prices, in that the gaps between supply and demand for any of the prices in that range is not very great. Surpluses that are created at prices high in this range are relatively small and will take time to become visible to traders and others.

But the same holds true for prices on the low end of this equilibrium range. Recall that oil prices back in 1999 were about $13 per barrel. At those prices, the shortage created is also small and takes time to become visible. But it did, and prices increased to more reasonable levels.