Supply and Demand in the Oil Market

Stan Collender just doesn’t believe that the volatile oil price can really be function of old-fashioned supply and demand:

It’s not that I’m not a big believer in this most basic rule of economics. It’s just that the higher prices seemed to come so suddenly and the increase was so steep that it was hard to imagine that supplies had fallen and demand had increased that dramatically or unexpectedly…

Does the recent very rapid drop in the price of oil put to rest the supply and demand common wisdom on oil prices?

I think that the main thing we can learn from the recent volatility in oil prices is not that the laws of supply and demand have been broken, or that they’re a function of anything else, but mainly that demand for oil is very inelastic, and that relatively small increases in demand can result in very large increases in price.

The idea behind demand curves is simple: if oil is more expensive, demand for it will fall. But as oil rose and rose and rose in price, from $10 to $30 to $50 to $80 to $120 to $140 a barrel, demand steadfastly refused to diminish. Meanwhile, supply from places like Mexico’s Cantarell oil field was falling. In such a situation, you’d expect oil prices to rise an enormous amount.

Eventually, it seems, at somewhere around $140 a barrel, prices were so high that demand did start falling off. Up until then, prices were on a steady upward path: they would keep on rising until they couldn’t rise any further. And in such a situation, you’d expect a bit of an overshoot, which woul explain "the recent very rapid drop in the price of oil," as well. Remember, the percentage drop in the price of oil is much smaller than the percentage rise in the price of oil which preceded it.

So count me in with the supply-and-demand True Believers. Remember that quote from an auction house specialist saying that "heaven is two Russian oligarchs bidding against each other"? In such a situation, where both individuals want the finite (=1) supply of paintings on offer, there’s really no limit to how high the price can go. The oil market is similar: so long as people will pay whatever it costs to have energy, there’s no cap to potential price rises. And that’s exactly what’s been going on of late.

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