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.

In this line chart, the horizontal axis displays years from 1861 to 2021. There are two vertical axes. One vertical axis displays the price of oil per barrel in 2014 dollars, and ranges from 0 to 140. The other vertical axis displays oil consumption in thousands of barrels, ranges from 30,000 to 120,000, and it is expressed in ratio scale, so consumption doubles at each consecutive step on this axis. Between 1861 and 1881, the oil price largely fluctuated between 20 dollars per barrel and 120 dollars per barrel. Between 1881 and 1921, it fluctuated between 20 dollars per barrel and 40 dollars per barrel (in 1918, at the end of the First World War, it was 30 dollars per barrel). Between 1921 and 1971 the oil price stayed approximately constant at almost 20 dollars per barrel - including in 1929 at the start of the Great Depression, and in 1945 at the end of the Second World War. It then increased dramatically during the first oil shock of 1973 to 1974, achieving 105 dollars per barrel during the second oil shock of 1979 to 1980. The oil price decreased to between 20 dollars per barrel and 40 dollars barrel during the 1980s and 1990s (including in 1990 during the dissolution of the Soviet Union), but increased to 100 dollars per barrel during the 2010s (at the start of the global financial crisis in 2008 it was 80 dollars per barrel). Between the late 2010s and 2021 the oil price decreased again to around 60 dollars per barrel. Oil consumption starts being recorded from 1965, when it was almost 0. By 1980, approximately 60 million barrels were consumed, and by 2021, over 100 million barrels were consumed.
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Figure 8.18 World oil prices in constant prices (1865–2021) and global oil consumption (1965–2021).

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.

In this diagram, the horizontal axis displays quantity, and the vertical axis displays price. A horizontal line corresponds to price c. This line crosses a vertical line at Q1. The OPEC supply curve, labelled Q OPEC, is a horizontal line at c stopping before Q1. The new OPEC supply curve, labelled Q-prime OPEC, is shorter than the previous line. At Q1, the horizontal line at c presents a kink and slopes upwards in an angle greater than 45 degrees. This portion of the line is labelled original supply. A straight, downward-sloping line intersects the original supply curve at quantity Q0 and price P0 and is labelled demand. Another upward-sloping, straight line is parallel to the original supply curve and is labelled new supply. It intersects the horizontal line at c at a quantity lower than Q1. It intersects the demand curve at quantity Q1 and price P1. The area between P1, the vertical axis, c, and Q-prime OPEC is OPEC profits. The area between Q-prime OPEC, c, the new supply curve, and P1 is non-OPEC profits.
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Figure 8.19 OPEC and the world market for oil.

The world supply of oil: In this diagram, the horizontal axis displays quantity, and the vertical axis displays price. A horizontal line corresponds to price c. This line crosses a vertical line at Q-bar. The OPEC supply curve, labelled Q OPEC, is a horizontal line at c stopping before Q-bar.  At Q-bar, the horizontal line at c presents a kink and slopes upwards in an angle greater than 45 degrees. This portion of the line is labelled original supply.
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The world supply of oil

Oil producers can supply oil at marginal cost (c) until they get close to capacity (\(\bar{Q}\)), when their marginal costs rise steeply. OPEC countries control a high proportion of total capacity.

Equilibrium in the world market: In this diagram, the horizontal axis displays quantity, and the vertical axis displays price. A horizontal line corresponds to price c. This line crosses a vertical line at Q-bar. The OPEC supply curve, labelled Q OPEC, is a horizontal line at c stopping before Q-bar.  At Q-bar, the horizontal line at c presents a kink and slopes upwards in an angle greater than 45 degrees. This portion of the line is labelled original supply. A straight, downward-sloping line intersects the original supply curve at quantity Q0 and price P0 and is labelled demand.
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Equilibrium in the world market

In equilibrium, a total quantity Q0 of oil is sold at price P0.

OPEC restricts capacity: In this diagram, the horizontal axis displays quantity, and the vertical axis displays price. A horizontal line corresponds to price c. This line crosses a vertical line at Q1. The OPEC supply curve, labelled Q OPEC, is a horizontal line at c stopping before Q1. The new OPEC supply curve, labelled Q-prime OPEC, is shorter than the previous line. At Q1, the horizontal line at c presents a kink and slopes upwards in an angle greater than 45 degrees. This portion of the line is labelled original supply. A straight, downward-sloping line intersects the original supply curve at quantity Q0 and price P0 and is labelled demand. Another upward-sloping, straight line is parallel to the original supply curve and is labelled new supply. It intersects the horizontal line at c at a quantity lower than Q1. It intersects the demand curve at quantity Q1 and price P1.
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OPEC restricts capacity

If OPEC restricts the quantity that it will supply from QOPEC to QOPEC, the world supply curve shifts to the left. The price rises substantially from P0 to P1.

Producer surplus: In this diagram, the horizontal axis displays quantity, and the vertical axis displays price. A horizontal line corresponds to price c. This line crosses a vertical line at Q1. The OPEC supply curve, labelled Q OPEC, is a horizontal line at c stopping before Q1. The new OPEC supply curve, labelled Q-prime OPEC, is shorter than the previous line. At Q1, the horizontal line at c presents a kink and slopes upwards in an angle greater than 45 degrees. This portion of the line is labelled original supply. A straight, downward-sloping line intersects the original supply curve at quantity Q0 and price P0 and is labelled demand. Another upward-sloping, straight line is parallel to the original supply curve and is labelled new supply. It intersects the horizontal line at c at a quantity lower than Q1. It intersects the demand curve at quantity Q1 and price P1. The area between P1, the vertical axis, c, and Q-prime OPEC is OPEC profits. The area between Q-prime OPEC, c, the new supply curve, and P1 is non-OPEC profits.
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Producer surplus

OPEC’s producer surplus is (P1c) × Q’OPEC, the area of the shaded rectangle. Non-OPEC producer surplus is the rest of the shaded area below P1.

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 2007–2008, 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.

  • Non-OPEC oil producers supply a higher proportion of world oil, holding the total quantity fixed at Q0.
  • The marginal cost of renewable energy production falls due to technological advances.
  • The greater availability of similarly priced substitutes to oil makes consumers more sensitive to oil prices.
  • Marginal costs of oil production for non-OPEC producers increase more steeply once production reaches close to capacity.
  • 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.

  1. According to the report, why was 2020 an unusual year for the oil market?
  2. 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.
  3. 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.