The End of Elastic Oil

Based on one of the Forbes article on 26th January 2012, the author, Tom Konrad has stated that the past 10 years have brought a structural change to the world oil market. The current economic issues that the whole world is unfortunately experiencing has become something of a conundrum for most people mainly because the majority of the population do not have any idea what it means and what exactly it entails. Why did the economy fall down? What are the reasons behind the increase of prices? These are the questions that a lot people have been asking themselves. That is why it is important that we truly understand the implication of this major problem that affects the globe.

As far as we know, the term demand and supply is some sort of a theoretical concept of price determination. It is ceased that during in a competitive market, the unit price for a good will digress until it settles at point where the current quantity demanded by consumers will equal the current quantity supplied by producers, which, resulted in an economic equilibrium of price and quantity. For the last ten years, the world’s oil market has brought into a fundamental change where changes of demand are vastly playing a role in maintaining the supply and demand of balance. These changes will come at a progressively distressing cost to our economy unless we start to take steps to make the demand of oil more flexible. As you can see the economic equilibrium below.

Oil which was formerly too expensive to exploit becomes economic with a rising oil price. To the imprudent observer, it might seem as if there is nothing to worry about in the oil market. Sadly, there IS actually something to worry about, well at least if we want to have our healthy economy back that is. The new oil reserves we’re now exploiting are not only more expensive to develop, but they also take much longer between the time the first well is drilled and the when the first oil is produced.  That means it takes longer for oil supply to respond to changes in price.

In economics definitions, the oil supply is slowly becoming less elastic as compared to new oil supplies which come in a greater extent from the unconventional oil.  Elasticity is a term whereby is the measurement of how changing one economic variable affects others. If a small change in price produces a large change in demand, demand is said to be elastic.  If a large change in price produces a small change in supply, then supply is said to be inelastic.

On the demand side, the elasticity of our demand for oil determines the variety we have to consume oil for our daily needs. At a personal level, we can quickly cut our demand for oil a little bit by associate it car trips, keeping our tires properly inflated, and such.  But the ability to make such cut-backs is often limited, and even such simple measures come at a cost of time or convenience, which is why we’re not doing them already.  If we live in an area without good public transport, we can’t stop driving to work without losing our job, so we keep driving to work, and paying more for the gas to get there. The graph below is one of many examples for the elasticity of demand.

Over the longer term, our personal options to cut oil consumption will increase.  We can move closer to work, or to somewhere where we can walk or use public transport to get to our job. This is why the most fuel-efficient vehicle is a moving van. Replacing a car with a more fuel efficient vehicle is an option for those who have money or credit, but the people who are under the most pressure from high fuel prices are unlikely to be able to afford such options.  If they can’t resort to ride sharing or public transport, they may simply lose their jobs because they can’t afford to get there.

The reduction in fuel use that comes from people losing their jobs and no longer commuting to work also contributes to the elasticity of demand, highlighting the point that while reductions in fuel use can be beneficent, they can also be harmful to the economy.  Reductions in demand due to high prices are often called demand destruction, and it is just as unpleasant as it sounds.

Since our options for reducing oil demand in response to rising prices range from inconvenient to highly extravagant, to downright painful, it is clear why the media and politicians focus so much attention on the other half of the equation which was when supply adapts to changes in demand, voters don’t have to make uncomfortable choices.

While fiscal issues constrain elasticity of supply, geology and politics constrain oil supply elsewhere.  Brazil’s giant pre-salt fields, like deep water discoveries in the Gulf of Mexico and elsewhere, are much more expensive and slow to develop than were past discoveries. 

In conjunction, if the oil were quick and easy to get at, we would have gotten it already. All these factors mean that the elasticity of oil supply is falling, so oil demand has to adjust more in response to changes in price than in the past.

Since there is little reason to assume that the elasticity of oil demand has changed significantly while the elasticity of oil supply has fallen, we have to expect that overall oil price elasticity has fallen as well, and these changes should show up in oil market data.

Since neither demand nor supply can respond instantly to changes in price, I had to estimate the average reaction time. To do this, I looked at the correlation between changes in the oil price and changes in supply and demand with various falter.  I used price and volume changes over a period of three years because three year changes gave me the strongest results, although one and two year changes were almost the same.

Hence, both elasticity of demand and supply has a fact that it got influenced by a few factors which was the closeness the substitution, the proportion of income spent on the good, and also the time elapsed since the price change.

*Random Fact: Petroleum is the official word for oil. The word petroleum is derived from 2 words in Latin means "rock" & "oil". 


By Rose Elida