A Primer on the Global Oil Market. The price of oil, which directly affects the price of gasoline, is determined by global supply (amount of oil/gasoline on the market) and demand (consumption of oil/gasoline). If there is more supply than demand (known as a buyer’s market), the price of oil/gasoline will decline. If there is more demand than supply (known as a seller’s market), the price of oil/gasoline will increase. But, one must remember how suppliers and consumers respond to these situations.
It is important to understand the term price elasticity. Elasticity refers to how consumers and suppliers respond to a change in the price of a particular good. Typically if the price of a good goes up, one would expect consumers to buy less or buy a substitute that is cheaper. If the price of a good goes down, one would expect consumers typically to buy more of the good. But what about the suppliers of those particular goods? If consumers are buying more of the good, then producers will produce more. If consumers are buying less of a good, then producers will produce less. The rate and speed in which consumers (demand) and suppliers (supply) respond to changes in price is what is called price elasticity. An elastic demand and supply curve means that both consumers and suppliers respond quickly to price changes. An inelastic demand and supply curve means that consumers and suppliers respond more slowly or less to price changes.
Global oil/gasoline has an inelastic demand and supply curve in the short run (the immediate time) and an elastic demand and supply curve in the long run (over time). To put it another way, there is a time lag in the ability of suppliers and consumers to respond to changes in the price of oil/gasoline.
Global Oil Market Principle #1 - In the short run the demand for oil/gasoline is price inelastic. In the long run, the demand for oil/gasoline is price elastic. This means that if the price of oil/gasoline goes up it does not immediately (short term) result in less demand. Why? There are few substitutes for oil/gasoline. It is difficult to reduce consumption (demand) or the use of oil/gasoline immediately. But, in the long run (over time) consumers do respond to higher oil/gasoline prices. How? Perhaps they begin to walk or carpool to work. They begin to ride public transportation. They purchase a more fuel efficient vehicle or an electric vehicle. Large corporations that consume oil over time will develop more fuel efficient machinery and technology. Over time, the high price of oil/gasoline does reduce consumer demand.
What if the price of oil/gasoline goes down? If the price of oil/gasoline goes down it does not immediately (short term) result in more demand. In the short term (immediately) consumers do not need to purchase more oil/gasoline. Why? One may not have a car or only have one car. Driving habits do not change immediately. But, over time or the long run, consumers may decide to purchase an additional car or a large SUV or truck or they may decide to take an extra vacation that requires more driving. A company may expand its operations. Over time or in the long run, the low price of oil/gasoline does increase consumer demand.
Global Oil Market Principle #2 – In the short run the supply of oi/gasoline is price inelastic. In the long run, the supply for oil/gasoline is price elastic. This means that an increase in the price of oil/gasoline does not immediately lead to an increase in supply. Oil companies cannot immediately increase the supply of oil/gasoline when the price increases because the production of oil/gasoline is expensive. Finding more oil, getting the oil out of the ground, increasing supply chain capabilities, and increasing refining capabilities take time and money. Over time when the price of oil is high, oil companies who are now making more money are able to find more oil, begin producing it, and increase supply chain and refining capabilities. Overtime, the high price of oil/gasoline increases the supply of oil/gasoline.
What if the price of oil goes down? In the short run, it is difficult for suppliers to reduce the supply of oil. Production of oil cannot be stopped quickly and global supplies chains and supply can’t just be reduced or stopped overnight. But, over time production sites can be shut down and supply chains can be adjusted to reflect less oil in the market. Overtime, the low price of oil/gasoline decreases the supply of oil/gasoline.
COVID as a case study…Prior to COVID there was a surplus in the global oil/gasoline market. In fact, at one point there was no place to actually keep the excess supply of oil. The price of oil/gasoline reflected this in very low prices at the gas pump. With the low price in oil/gasoline, oil companies over time began to cut back on oil/gasoline production (supply). The global COVID pandemic then appeared and the demand for oil/gasoline declined even more dramatically. Oil companies continued to cut back on oil/gasoline production (supply) because of the reduced demand due to COVID economic restrictions, less travel, etc. The arrival of vaccines and a return to more “normal” global economy led almost overnight to a dramatic increase in demand for oil/gasoline. But, in the short run, oil companies haven’t been able to respond to the increased demand. Why? It takes time to ramp up the supply of oil. Increasing production, increasing refining capabilities and global supply chains for oil which had been cut prior to and during COVID have to be reestablished. COVID is still making this extremely difficult and the situation in Ukraine doesn’t help. Thus, in the short run, where we are now, the demand for oil is greater than the supply and the outcome is higher prices.
But, over time or in the long run, oil companies will respond to higher prices and the supply will increase which will eventually bring down the cost of oil/gasoline. Also, consumers will respond to the higher prices over time by turning to alternatives, such as electric vehicles. Corporations will turn to alternatives (natural gas, green energy) and develop even more efficient machinery and technology in response to the higher prices. Overtime, suppliers and consumers will respond to higher prices which will eventually bring down the price of oil/gasoline and will help to reduce overall inflation.
Manipulating the supply and demand of oil/gasoline for political purposes is another topic and another essay…
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