Module 1- Case Oil - Demand and Supply BUS305 - Competitive Analysis and Business Cycles July 31, 2012

INTRODUCTION In this case study, I will explain the laws of supply and demand, providing an explanation of

Oil Prices - Demand and Supply these concepts as they pertain to the commodity, oil. Ill illustrate the interaction of the demand for and supply of a commodity -in this case -crude oil, the determination of its market price, and the equilibrium quantity that is produced and consumed.

BODY Demand & Supply Demand refers to the amount of a commodity that is demanded by consumers at any given price. According to the law of demand, demand decreases as the price rises. Supply refers to the varying amounts of a commodity that producers will supply at different prices; in general, a higher price yields a greater supply (Columbia Electronic Encyclopedia, 2011). According to the Columbia Electronic Encyclopedia (CEE), in a perfectly competitive economy, the combination of the upward-sloping supply curve and the downward-sloping demand curve yields a supply and demand schedule that, at the intersection of the two curves, reveals the equilibrium price of an item. That being understood, lets look at oil prices and the concepts of demand and supply. Oil Prices Demand & Supply: Why Doesnt it Work? Many factors affect the price of oil in the world market. The two largest consumers of petroleum products are the United States and China (Anderson & Buol, 2005). Normally, in the U.S. market, when a commodity such as oils demand increases, supply also increases, thereby creating a sort of demand/ supply equilibrium, thus controlling the price. Europes prices however are tied more to the price of crude by long term contracts, making it extremely hard to keep the cost of their refined oil products down. At this point, the interaction between oil demand and oil supply world-wide isnt working in the way most people expect it would. Even if the price of oil rises, world oil production doesnt increase by very much, if at all. This aids in

Oil Prices - Demand and Supply sustaining high oil prices. The following figure illustrates the world supply capacity for oil vs. the historical supply trend. The chart shows that supply started lagging demand as early as 2005.

Recently, the rapid increase in world oil demand has been a major pricing factor. In August 2004, the International Energy Agency reported that world oil demand was increasing faster than at any other point in the past 16 years (Anderson & Buol, 2005). According to Trading Today (2012), oil demand will continue to increase regardless of the high price of oil. There are many sources of demand for this commodity. As countries develop and industrialize, their oil consumption grows along with their growing economy. China and India are in the throes of rapid economic development, As such, these two countries are rapidly expanding their industrial development and the impact on oil demand has already begun (Trading Today, 2012). Scenarios What does all of this mean to you and me, the end users of oil and its derivatives? To explain, lets examine some hypothetical situations and their impact on the price and supply of oil as a result of those events. Lets say that households world-wide increase the demand for hybrid and electric vehicles. Since hybrids and electric vehicles use little to no petroleum products for their

Oil Prices - Demand and Supply propulsion, petroleum demand would see a gradual drop, as production ramped up on the alternative fuel vehicles. However, the production process of those alternative vehicles would include the use of many petroleum based products, such as lightweight plastics, so there would be some temporary offset to that drop in demand. Be that as it may, in this scenario, as the demand curve drops, so does the supply curve, thereby reducing the price of oil to a lower equilibrium level. Lets suppose that new crude oil reserves are discovered in Venezuela. The impact on supply might just be minimal, since they have undergone turmoil that has affected their abilities to produce at full capacity. Historically, political problems were exacerbated by a nationwide strike in December 2002. The strike led to significant reductions in the country's GDP and oil production. The EIA reports that Venezuela produced 2.6 million bbl/d in 2003, a 10 percent decrease from 2002. The strike, which lasted until early 2003, significantly reduced total oil production. Since that time, production has been returning to levels seen before the strike; however, there are still reasons to doubt the country's progress. In August 2004, President Hugo Chavez survived a recall vote to remove him from power, and there is no guarantee this will be the only attempt. Such uncertainty has led some to question the ability of Venezuela to continue to produce a steady flow of oil (Anderson & Buol, 2005). In this scenario, Venezuelas gain in reserves might never reach the world market to offset the ever increasing demand curve for petroleum, causing oil prices to continue their steady increase. Lets say that petroleum products are used as a factor of production and that production increased significantly. This will increase the demand for oil and shift the demand curve higher causing the supply to increase and likewise the price, until it reaches a higher level equilibrium.

Oil Prices - Demand and Supply Price Controls I still remember the last time that government intervened and imposed price controls on gasoline. In the 1970s, the Nixon and Ford administrations imposed price controls on gasoline. They were reacting to rising gas prices caused by OPEC's cuts in production. But what followed were long lines at gas stations and an artificial shortage of gasoline. Experts say the most likely outcome of price controls is gas rationing, like what we saw almost 40 years ago. People panicked to make sure they didn't wind up without gasoline and gas stations only stayed open a few hours a day to empty their tanks. Since they couldn't raise prices, they would close shop after selling out. And those who didn't want to wait in long lines bought gas on the black market at steep prices (Cafferty, 2012). CONCLUSION Oil prices, in my opinion, arent going to lower much anytime soon, without some kind of shock. A new crude oil strike or other event that increases supply significantly would be required to offset the increasing world-wide demand for the black gold. As suppliers reach their maximum capacity to produce, and that level continues to lag demand, higher prices are inevitable.

References Columbia University Press (2011), Columbia Electronic Encyclopedia, 6th Edition; 11/1/2011, p1-1, 1p. Retrieved from: http://web.ebscohost.com/ehost/detail?sid=e10f0c59-f102-4a90-b7f9dcde06d4c841%40sessionmgr12&vid=4&hid=13&bdata=JnNpdGU9ZWhvc3QtbGl2ZQ%3d%3 d#db=lfh&AN=39034443

Oil Prices - Demand and Supply Anderson, R and J. Buol (2005). "What is Driving Oil Prices." The Regional Economist. The Federal Reserve Bank of St. Louis. Retrieved from: http://www.stlouisfed.org/publications/re/2005/a/pages/oil_prices.cfm Tverberg, Gail (2012), Why Oil Prices are So High: Production Shortfall, Iran Concerns, and Low Interest Rates. Our Finite World, February 26, 2012. Retrieved from: http://ourfiniteworld.com/2012/02/26/why-oil-prices-are-so-high-production-shortfall-iranconcerns-and-low-interest-rates/#more-16059 Tverberg, Gail (2012), Evidence that Oil Limits are Leading to Declining Economic Growth. Our Finite World, July 13, 2012. Retrieved from: http://ourfiniteworld.com/2012/07/13/plan-forlower-growth-in-real-gdp-going-forward/ Trading Today (2012), Oil Supply and Demand, Trading Today, July 29, 2012 Retrieved from: Oil Supply and Demand Janssens, Tom, Nyquist, Scott, & Roelofsen, Occo (2011), Another Oil Shock?; McKinsey Quarterly; 2011, Issue 4, p74-83. Retrieved from: http://web.ebscohost.com/ehost/detail?sid=00a3a71f-2d05-4d1d-82eee5bbeff7d95a%40sessionmgr104&vid=5&hid=125&bdata=JnNpdGU9ZWhvc3QtbGl2ZQ%3d %3d#db=bth&AN=67227987 Cafferty Jack (2012), Should Price Controls be Imposed on Gasoline?, CNN Cafferty File, July 29, 2012. Retrieved from: Should price controls be imposed on gasoline? Cafferty File CNN.com Blogs