Unit 8 Supply and demand: Markets with many buyers and sellers
8.8 Application: Market dynamics in the oil market
The price of oil is determined in a world market. Oil companies find, extract, refine, and transport oil from countries that have oil reserves. The US and Saudi Arabia were the biggest producers in 2020.
The amount of oil available for sale depends on the access to the natural resource and the related decision by profit-maximizing firms about the quantity to sell. The processes and technologies for finding and extracting oil are fixed in the short term, because it takes time to introduce changes and identify new sources of oil. In the short run, supply is relatively inelastic.
Demand from oil comes from many different, often large, sectors in the economy. It is an input to transportation, electricity generation, heating, and production of many consumer products including smartphones, clothes, make-up, toothpaste, medicines, and carpets. The demand for oil depends on how demand for these products changes and on whether alternatives to oil can be used in production processes. As with supply, demand is relatively inelastic in the short term as it takes time to adopt production processes and transport technologies with alternative inputs.
Figure 8.18 plots the price of oil in world markets (in constant 2020 US dollars) and the total quantity consumed globally from 1965 to 2021. To understand what drives the fluctuations in the oil price, we can explore the short-run and long-run changes in supply and demand.
Figure 8.18 World oil prices in constant prices (1865–2021) and global oil consumption (1965–2021).
BP. 2021. BP Statistical Review of World Energy 2021.
From the late 1800s to the early 1970s, oil prices were at a relatively low and stable level. During this period the technology changed; costs of exploration and extraction fell, and global trade opened up, leading to an increase in supply. The natural resource had become less scarce and less costly to produce and transport.
- cartel
- A group of firms that collude (work together) to set output and/or prices in order to raise their joint profits.
Global economies were shaken by the steep rise in oil prices in the 1970s. The members of the Organization of the Petroleum Exporting Countries (OPEC), formed in 1960, together controlled a high proportion of global oil resources. They began to work together as a cartel, restricting access to Middle East oil and hence raising prices.
Figure 8.19 shows how OPEC was able to affect the world oil price by limiting its own supply.
Figure 8.19 OPEC and the world market for oil.
The world supply of oil
Equilibrium in the world market
OPEC restricts capacity
Producer surplus
Figure 8.19 illustrates a case where the assumption that no one can influence the market price fails. Initially, the market was in competitive equilibrium with oil producers acting as price-takers. But when the OPEC countries worked together in the 1970s, their high market share gave them considerable market power. By jointly restricting their own supply, they raised the price substantially and increased their profit.
This restriction in supply was offset in the 1980s by a significant fall in demand for oil, linked to low levels of economic growth.
The upward trend in oil prices from the 1990s came again from a period of restricted supply, linked to political instability in the former Soviet Union and later in the Middle East due to the Iraq War, and to the continued dominance of OPEC. The limited supply was matched by a reduction in demand and wider commodity credit restrictions for a short period around the time of the global financial crisis of 2007–2009, but this did not last long. In particular, restrictions in supply in 2011 were linked to political turmoil in OPEC countries, such as the Arab Spring in Egypt and Libya. Limits on the number of barrels sold to the global market interacted with increased demand, particularly in the production of consumer products, which resulted in a high equilibrium price.
Since the global financial crisis, there has been an overall decline in the oil price, with some peaks along the way. This has been driven by a mix of changes in supply and demand.
As the price of oil was high for a sustained period of time, consumers—large industrial users of oil—sought out ways to reduce their demand. For many of the sectors that use oil as an input, there were also external pressures to switch to cleaner fuels, notably in electricity generation and transportation. Shifts in preferences towards non-fossil fuels due to climate change, and budget constraints, have led to a steady slowdown in the growth of oil consumption—most evident since 2015.1 The decline in consumption in 2020 reflects the significant economic effects of COVID-19 containment measures, including reduced production of goods that use oil as an input, and reduced travel and transportation.
In parallel, as the oil price rose, producers of substitute products saw scope to earn rents and offer alternatives to consumers. Shale oil, shale gas, liquefied natural gas (LNG), renewable energy, and electric vehicles are examples of product development and growth that have affected the demand for oil. Substitutes emerged because of technological developments facilitating growth in these sectors and the opportunity to profit from moving into markets previously largely associated with oil.
Changes in demand and entry of new substitutes also affected the decisions of oil companies. With alternative fuels available, the ability of the OPEC cartel to influence the market price of oil is reduced. This increases the chance that a member of OPEC will choose to break the agreement and supply more to the market. The disruption from new products affects the strategic interactions within the cartel, the incentive to supply alternatives, and the nature of demand for oil.
Markets are dynamic, and the history of the oil market shows clearly that we need to understand the fundamentals of supply and demand to interpret price changes. No doubt the market will continue to evolve and there will be further periods of price rises–as occurred with the outbreak of the Russia–Ukraine war in February 2022–and price reductions.
Question 8.10 Choose the correct answer(s)
Figure 8.19 illustrates the market for oil at a point in time, with price determined where demand is equal to the world supply. The world supply curve includes supply from OPEC countries at the fixed cartel price (the horizontal portion) and the supply from non-OPEC countries (the horizontal portion after QOPEC and the upward-sloping portion). Based on this information, choose the condition(s) under which the equilibrium price of oil would increase.
- This scenario is analogous to a leftward shift in the world supply curve (OPEC producers supply a smaller quantity of oil), which raises the equilibrium price.
- This scenario would cause the demand curve for oil to shift downwards as economies increase consumption of renewable energy, which reduces the price of oil.
- The availability of substitutes would make the demand curve less steep (consumers are more price-elastic), so the new equilibrium price cannot be higher than the current equilibrium price.
- The upward-sloping portion of the supply curve would become steeper, so the equilibrium price would be higher than P0.
Exercise 8.8 The world market for oil
The oil market is constantly changing, and 2020 was a particularly unusual year. Use BP’s Statistical Review of World Energy (pp. 1–9) to answer the following questions.
- According to the report, why was 2020 an unusual year for the oil market?
- The ‘Oil market in 2020’ chart shows the changes in demand and supply over three time periods (December 2019–April 2020, April–August 2020, September–December 2020), along with information about global oil stocks and oil prices. Assume that the global oil market was in the equilibrium described in Figure 8.19. For each time period, draw a diagram similar to Figure 8.19 to show these changes in the oil market, making sure that the outcomes are consistent with the information in the chart.
- Identify one trend or recent development discussed in the report, and explain how it will likely affect the market for oil (supply, demand, equilibrium price/quantity). Use a diagram to illustrate your answer.
