For those of you who have never studied economics ( or indeed have any great desire to) a basic understanding of how supply and demand works in other markets will certainly help you when looking at the trading oil market, which as we will see is very different. So let’s start by looking at how supply and demand works in more conventional markets and then how it differs in oil commodities. The study of supply and demand within a market is often called micro-economics, as opposed to macro economics which considers the bigger picture issues which affect a market.

supplydemandoilMost markets work on a very simple principle of price and demand known as price elasticity, where market prices are completely elastic ( or relatively so). In other words if the price goes up, then demand falls, and if the price falls then demand rises. One can apply this very simple model to virtually any market or sector one cares to think of such as cars, holidays, clothes, food etc. So price and demand correlate inversely and the markets are said to be perfectly elastic, so we have a downward slope to our graph. Now whilst demand explains the consumer side of buying decisions, what about the relationship between price and supply for the producers? The price supply relationship is the exact opposite of that of price demand. As prices rise so does supply, and as prices fall so will supply – the two correlate directly, which might appear strange at first glance, but if we stop to think it does make sense. If the market can only support a low price, then only the most efficient suppliers will compete, but as prices rise, more suppliers enter the market as even the inefficient producers are able to make a profit. Hence as prices rise, so does supply coming onto the market. If we add these two effects together then the market price is the point at which the two graphs meet and is where the level of demand will meet the level of supply, as shown in the chart alongside. So does the same model apply to the price of oil when you are trading oil – well yes and no!

The oil market behaves differently for several reasons. Firstly of course it has a finite supply and will eventually run out. Secondly it is not a product that  attracts new suppliers to the market as prices rise, since the cost of entry is extremely high. However what higher prices do encourage longer term is investment in prospecting to discover new sources for oil commodities, or investment in alternative or more efficient extraction processes in some of the more hostile environments. Finally it is a highly inelastic market, being practically immune from price sensitivity, since the world as a consumer has little alternative in the short, or even medium term. Whatever fuel may cost, the transport industry has very little alternative but to continue buying, whatever the price may be. Industry is the same with higher prices simply absorbed into production costs or passed on in higher retail prices. So our price demand graph is almost vertical with large price movements having relatively little effect on demand. In the recent price movement to $146  a barrel, the reduction in demand was negligible, the only noticeable effect being a slight reduction in private car usage.

Our supply demand relationship is also inelastic but for different reasons. Firstly, most oil trading companies will work at full capacity for most of the time, since the saving in costs of operating the plant at a reduced capacity is minimal, therefore most plants will produce the maximum all the time. Secondly, identifying and extracting new supplies of crude oil is costly and time consuming and even more so today as extraction becomes increasingly difficult in politically and geographically hostile environments. As a result worldwide oil production has barely increased since the middle of 2004, with demand rising at an increasing rate as the new economies of China and India begin to flex their industrial muscles. Currently the Chinese consume approximately 7 million barrels a day, but in the next 20 years it is forecast that this will exceed that of current US demand. The net result is that a small change in the supply demand relationship can result in large changes in the market price in the short term. In the longer term the oil market can and does move more closely in an elastic model, as was seen following the Middle East events in the early 1970’s, but only several years later once legislation had been introduced to limit traffic speeds, and manufacturers began to design more fuel efficient cars. No doubt the same principle will apply once alternative sources of energy start to become more widely available and profitable for manufacturers to produce.

In summary, my views on future oil prices are as follows. Firstly, in the short term, even though the price of oil may fall, longer term it will continue to rise, since at some point in years to come supply will be exhausted and will not be able to meet demand. This does offer the interesting prospect of course of oil prices falling, due to excess supply with a lack of demand, with industry and commerce running on alternative energy sources! Secondly, I am often asked why prices spiked to the dizzy heights of almost $150 a barrel. My own view is that this has been based largely on speculation ( us oil traders again!) taking the view that with demand increasing dramatically there will be insufficient in future to satisfy demand – not an unreasonable assumption to make in crude oil trading. However, purely blaming this on speculation tends to miss the bigger picture. The oil trading markets, just like any other are far from perfect, and whilst in the short term it may be subject to speculative pressures, longer term the supply and demand curves will start to apply as more traditional economics comes into play.

Be Sociable, Share!