Low oil prices have caused many to rejoice and applaud President Obama and the role he played to create this 12-year-low, but some are taking a deeper look to better understand why this may have happened.
Marcelle Arak, a professor of finance emerita at the University of Colorado Denver, and Sheila Tschinkel, a former Resident US Treasury Economic Advisor in several Eastern European and Central Asian countries, both took a look at the economics behind these new oil prices.
In Economics 101, the first rule of profit is through supply and demand. If you have more supply than demand, prices tend to decrease drastically. That would then mean that you should cut back on supply so that you can maintain the same price.
That obviously isn’t so for oil prices, and as Arak and Tschinkel point out. The oil market has always marched the beat of their own drum—sometimes to their own dismay.
According to reports, oil production, despite the lowering demand, has actually increased, leading the International Energy Agency (IEA) to warn this week that markets could “drown in oversupply.”
To put this in concrete terms, the IEA reports that the global oil supply averaged 96.9 million barrels a day in the fourth quarter of 2015, up from 95.4 million a year earlier. At the same time as the supply has increased, demand was down by almost 2 million barrels (at about 95.1 million) and is expected to continue this decline in the current quarter.
In fact, demand is so low compared to supply that there are barrels of oil sitting in storage, waiting to be used. This, in turn, sharply reduces oil prices.
Arak and Tschinkel are then led to ask two more questions: “if prices have fallen so much, why doesn’t demand increase? And if demand and revenues are down, why don’t producers just turn down the taps?”
One factor to consider is that in the short-term, demand is rarely affected by price. That is to say that if you lower the prices by one percent, there isn’t necessarily an increase in demand that month.
If someone is driving a brand-new gas-guzzling Hummer, he or she isn't necessarily going to buy a Prius if prices rise. In the same way, someone driving a Prius isn’t going to jump at the opportunity to buy a Hummer if gas prices go down — at least, not within a short amount of time.
“Thus, the current situation reflects a highly competitive market and a weak response from customers in the short run,” Arak and Tschinkel note. “The current global rate of economic growth, the state of technology and things like the weather determine the demand for energy more than price.”
Okay, so the next question is simple: why don’t producers just simply curb their supply?
Well, it isn’t one company that owns all the oil in the world — that means that unless everyone curbs their supply to increase prices, a few of the companies that do not do so will get a “free ride” and remain fairly happy with their revenue.
“Today, that kind of cooperation is much less likely, as oil-producing countries don’t appear interested or even able to work together to raise prices – let alone do so unilaterally,” Arak and Tschinkel added. “They have varying foreign policy interests and economic structures. The biggest producer, Saudi Arabia, is even accused of purposely trying to keep prices low to run upstart American producers out of business.”
To add to it, when prices increase, businesses and motor companies work to make more fuel-efficient machines, thus making the demand for oil lower. When the prices decrease, demand eventually responds by increasing (note: eventually).
In short, if the supply continues to increase and the demand continues to remain unresponsive, prices will continue their slow decline.
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