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The Economics of Oil

March 25, 2012 | About:

Josh Zachariah

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The economics of oil and its derivative gasoline are a very unique and complex situation. Often as oil prices rise, people predict and fear even higher oil prices even when this is inconsistent with basic economics. In most situations, increases in a price of a good should be followed by a decline in demand. However, in the case of gasoline this is not the case in the short-run.

This phenomenon is explained by the concept of elasticity. Elasticity conveys the change in demand based on a change in price. This statistic is negatively correlated as an increase in price most always is followed by declines in demand though certain luxury goods may show an exception. An inelastic good is one in which an increase in price is followed by little or no change in demand. As I wrote with great surprise in a previous article, Coca-Cola has in fact a relatively high elasticity indicating the company doesn’t have great ability raise prices without consumers cutting back on consumption.

Why gasoline prices tend to exhibit inelasticity in the short-run can be explained by a little bit of intuition. Consider a 30% rise in milk and gas prices. In the case of milk people can easily substitute out to other goods. Perhaps it would be oatmeal instead of having cereal or some other protein rich food, but consumers can adjust their consumption for milk immediately. That’s not the case with gas as it takes time to cut back on gasoline consumption. Consumers can move closer to work and they can buy more gas efficient cars, but these changes can’t be taken immediately. Hence consumers are at the mercy of gas prices in the short-run, but can adjust in the long-run.

Looking outside the US and demand for gasoline is even more complex. Countries such as Nigeria, Egypt, India, China, Saudi Arabia and many others subsidize the cost of oil for their citizens. Sometimes the price is held fixed until the government decides to raise it as China is doing now. In the case of Nigeria the government is met by large protest by any threat of axing subsidies. The price per gallon of gas in Saudi Arabia is some $0.14. Saudi’s must flush gas through their combustion engines like us Americans flush gallons of water down our toilets; they don’t even think about the cost.

Most of the subsidizing countries such as India and Egypt are experiencing gaping deficits as they have to flip the bill for higher oil prices. In this respect it’s much more efficient for the US to let consumers incur the higher costs as it encourages more prudent consumption.

Subsidies also make the calculation of the oil price all the more intricate. If these countries decide to raise prices, demand will certainly become muted and perhaps immediately. If these consumers run tighter budgets than Americans then they may not have the ability to pay more for oil.

A supply disruption in Iran has become the centerpiece to the speculation in oil prices. Were it to happen prices would definitely rise as consumption could exceed production. Prices would be the arbiter in this situation and as the price goes up, those countries unwilling to pay the price won’t get their oil.

But is this fear misplaced? Can Saudi Arabia plug the gap as they claim and churn out more for the lost barrels of oil from Iran? This brings us to another concern of the oil market; the lack of accurate data about reserves and production. OPEC countries have been accused of overestimating their reserves in order to produce more as production quotas are contingent on total reserves. I won’t belabor this topic, but note that The Oil Drum is a great website that elucidates much of this complexity.

As I mentioned before, it is much more efficient to pass on higher costs to consumers rather than letting the government pay the oil bill and thereby inoculating consumers from the higher price. If in fact oil is becoming more and more dear it would be our advantage to adjust to that reality. If we in the US continue to curtail our consumption and move to efficient means of moving goods around we’ll have a distinct edge over the nations that insulate their population from the high prices and continue to consume oil unproductively. This will contribute to a lower cost structure in our means of production. Looking at the below chart of oil consumption in the US we can see it dropped from a peak of about 22 million barrels per day in 2006 to just under 18 million barrels per day most recently.

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The recession surely contributed to the decline, but as energy economist James Hamilton points out, the high oil price in 2007-2008 likely influenced declines in consumption. US economic output has grown over the years while oil consumption has declined. For all the concern of “peak oil” the US looks to be better prepared to navigate that storm than most countries.

About the author:

Josh Zachariah
I credit my father and Warren Buffett for molding me into the investor I am today.

Rating: 3.7/5 (10 votes)

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