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Indexology®: The Simple Economics of Oil

Now that the shock of oil under $75 per barrel and gasoline under $3 per gallon has begun to wear off, the debate has shifted to when oil prices will rebound.

A look at the economics of supply and demand suggests that the rebound probably won’t take prices back over $100 that quickly. Unlike earlier oil price collapses, this time both demand and supply moved and both pushed prices down. The collapse of oil prices when the global financial crisis morphed into the Great Recession was driven by plunging economic activity and plummeting oil demand. The oil price drops in the early 1980s were driven by increased supply from the North Sea; falling oil prices after the first oil crisis in 1973 reflected slower economic growth and weak demand.

This time around expanding oil production in the US, largely from shale in Texas and North Dakota, are expanding supply while slowing economies in Europe and Japan, and slower economic growth in China are shrinking demand for petroleum. The result is a large drop in oil prices. The diagram shows why getting back to the prices seen last summer would require reversing both these moves. The initial picture in the summer was demand marked D1 and supply marked S1 intercepting at A. Then the supply curve shifted outward to the right so that more oil would be supplied across the range of prices. Now demand D1 and the new supply curve S2 meet at B, price is lower and quantity is larger. This was followed by a fall in demand which shifted from D1 to D2. The new intersection is C and prices are further down. Oil consumption is lower at C than B because demand is less.

Were supply to completely reverse, prices would move to E, but the price rebound would not be complete. Likewise, were demand to expand and return to D1, prices would not return to A. Only the combination of reversing both these moves could put prices back to the levels seen in June and July 2014. Since the new fields in Texas and North Dakota are online and producing, a complete reversal of the supply increase is unlikely. There is some price which is low enough to make production uneconomic; but price needs to only cover operating expenses – the capital investment for exploration and development is a sunk cost. Speculation in the media about what price would force a production shutdown varies from $70 down to $40 or maybe less.

The price gyrations over Thanksgiving weekend are largely a response to OPEC’s decision not to cut production back. Just as prices settled into a range between $85 and $110 in 2013 and the first half of 2014, it is possible that a new range centered near $75 will develop going forward. However, neither that $75 range, or any other price point, will last forever.

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