Principles Of Microeconomics
The paper will discuss and analyze the oil market. Much of the world still runs on fossil fuels, of which oil is a prime example. Oil is an essential good, supplying 33% of all energy, and is the world's primary fuel. Used mainly in transportation and industry, oil is a critical part of development and trade (Clemente). Although, as a good, it is quite homogeneous without many substitutes available, due to technological developments and a rise in prices, new alternatives are becoming more and more popular. Crude oil may be used in different industries, the most popular of which is the automotive industry. It is also widely used in the production process of chemicals, waxes, asphalt, plastics, fertilizers, polymers, heating and many more products used in everyday lives. Crude oil is a tangible commodity and therefore is possible to store, however, long-term storage may be quite expensive.
The oil prices can be different in some regions due to different supply and demand and slightly different quality, but due to the globalization in place, the prices are moving closer together. Being such an essential resource, politics has been a constant factor in defining the price of oil (History). From 1940, up until today, the impact of geopolitical events has had a direct effect on the prices of oil. OPEC, an organization of essentially all oil producers in the Middle East, has a huge influence on the market (Williams). The members hold almost half of the world’s oil production and have the majority of the world’s proven oil reserves in their ownership. An example of how this has affected the market in the past is the Yom Kippur war, where an embargo was imposed on all countries that supported Israel, causing a 400% increase in price. Another geopolitical event affecting price was the invasion of Iran by Iraq, both members of OPEC and critical producers of oil. This caused a huge decrease in supply, lowering worldwide oil production by 10% and increasing prices from $14 to $35 per barrel in 1981 (Reisdorf). When looking at the history of the price of oil we see some main factors affecting it; war, governmental reforms and OPEC’s drastic influence in supply. This has caused constant fluctuations in the global market price for crude oil.
Oil has a very complicated and politically charged history. Nonetheless, the demand for the good has continued to increase in emerging markets and is expected to continue to rise. As seen in the graph above (Charting), the consumption of oil increases as time advances, with some dips in certain periods. These dips are due to an extended period of considerably high-priced oil, causing consumers to reduce their energy consumption and decreasing overall demand. A prime example of this is 1973, which can be seen in the graph as a dip in the curve. This resource plays a vastly dominant role in the global economy. It is the central resource for transportation, from transporting goods through international trade, to allowing households to commute to work every day.
As the world continues to develop on a global level, the demand for oil continues to rise. Oil, as a good, shows an inelastic demand. This is displayed by a relatively insensitive global demand to price change. As oil prices rise, the demand stays relatively stable. This is because there are no readily available, affordable substitutes to using oil as a source of energy. Developed countries, accounting for around 45% of world oil consumption, have plentiful resources allowing them to look for alternative energy sources. This causes their domestic oil consumption to increase at a lower rate. This, however, is hindered by developing countries, which are much more dependent on oil. These countries do not have the resources to substitute their energy source and are therefore playing a big role in the continuous increase in global oil demand. This can be seen in the below graph, where the inelastic demand curve shifts right.
Historians believe the first oil was discovered by the Chinese in 600 B. C. With the dawn of the 20th century, new technologies led to a shift from coal to oil, which was considered a much more adaptable and flexible energy source than coal and set the stage for the new oil economy. As the automotive and the lightbulb industries grew exponentially, demand for oil was increased, as was the supply of it. Beginning with World War I, big nations, such as the US and the UK, realized the tremendous geopolitical and strategic asset oil can be, and decided to invest in exploration, production, pipelining and refining operations around the world. They consequently set up production facilities in Iran, Kuwait, Saudi Arabia, and even Libya to ensure sufficient oil for their army.
For much of the 20th century, global oil supply was dominated by only a few American and British ‘super-majors’ known as the Seven Sisters and set up the price per barrel globally. As the Seven Sisters set up production facilities around the globe, governments of many of these Middle-Eastern countries saw themselves as instruments of the industry and began to assert control over their domestic oil reserves. In 1960, these governments founded an alliance called OPEC, in response to the Seven Sisters’ efforts to drive oil prices down, to maintain their control over their income. Today, OPEC continues to have a lot of influence over the price of oil, as 81% of the oil reserves in the world belong to them (Oil). Until the late 20th century, the oil market was an uncompetitive one, controlled by only a few entities and the supply was therefore elastic. This type of market is called an oligopolistic market structure, which has a few producers and a large number of buyers which gives these producers an advantage to control the market (Answers). Today, technological breakthroughs in unconventional oil and gas production have started to drastically cut the production cost per barrel of oil and is shifting power away from these big entities like OPEC. Hydraulic fracturing, horizontal drilling, and deep-water production have contributed to the overall decrease in supply elasticity, a rise in competitiveness in the market, and a decrease in price per barrel. As seen in the graph, in 2006, the US was at a low point, importing 60% of its oil. Thanks to developments in fracking technology, they are now world leaders in oil production and are shifting the global supply curve to the right, shown below (Mclean).
The above graph is displaying the most recent changes in supply and demand, since 2006. Although global demand rises from D1 to D2, due to a rise in oil consumption mainly in developing countries, oil showed a significant drop in its price, because of the shift in supply from S1 to S2. As supply increases, with a shift to the right, the price decreases. This decrease in price, along with an increase in quantity supply and demand, is shown by the new equilibrium point, E2.
Externalities
In a world where social conscience and environmental awareness is constantly growing, society is looking for new, renewable and harm-free energy sources. This is due to overwhelming negative externalities caused by oil production. Oil spills at sea, disruption of habitats, harmful emissions and countless other issues raised by oil production and consumption place oil as one of the biggest causes of climate change in the past century. As climate change becomes a more pressing issue, awareness of oil’s destructive factors is increasing, and alternative solutions are coming forward. Wind, hydro and solar power are some prime examples of renewable energy that are increasing in consumption, relatively lowering oil consumption in developed countries. The U. S, in 2018, was producing 90,004 MW of total installed wind capacity, enough to power over 27 million average homes with clean and affordable energy (Record).
On top of its extensive environmental issues, the oil industry has other negative externalities, although perhaps not as destructive to society. With a limited supply of oil, by consuming it we are depriving future generations of it as a resource. This industry also causes a large security risk to a country, since it comes with a high political and military cost in order to maintain access to its resources (Record). Although measurements such as those above may reduce negative externalities of oil, one of the tools used by most developed countries are taxes, shown below.
As demand for oil is relatively inelastic, and therefore price volatility does not significantly affect oil consumption, oil-consuming nations have imposed heavy taxes on their consumers. As shown in the graph, the average price per liter of oil is composed of almost 60% of taxes (Taxes). Taxation is mainly used to increase the consumer’s awareness of the negative externalities of the consumption of oil but is also considered an important source of income for these governments. However, due to the sharp decrease in the price of oil, revenue for these countries decreased, and governments try to increase their already substantial taxes.
An example of an attempt to increase taxes on oil was the French’s government ‘eco-bill’ to fight climate change. The bill was quickly ruled out, as it was met with a heavy backlash of angry protesters around the country, who had a hard time accepting the immense tax levied on a good they are heavily dependent on (Crooks).
As the price of oil has been highly volatile in the past century, so did the consumer and producer surplus. As a very inelastic good, consumers are willing to pay a very high price to continue consuming the good, meaning their consumer surplus is very high. In the past year, due to a sharp increase in production levels around the world, which led to a decrease in the good’s price, consumer surplus increased even more, raising consumer welfare for oil consumers. Moreover, this decrease in price led to a decrease in the producer’s benefit in selling oil, hence decreased the producer surplus.
References
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