24 December, 2010

Oil Price Forecast (made in May 2010)

The world economy is highly dependent on oil as the main energy source. Level of accessibility to oil sources determines the strength and weakness of a nation in domestic and international sphere. Not all countries are able to produce all the oil they need. There are only thirty-two net-exporters (countries) most of which are member of Organization of the Petroleum Exporting Countries (OPEC) (Nationmaster n.d.; OPEC n.d.). Both importers and exporters depend on trading for selling and buying, and price is a key component of trading. This is because price has rationing and allocating function of the scarce resources. This paper will argue that by the end of 2010 the price of oil will reach US$83 per barrel.

Price is determined by demanded and supplied quantity and non price determinants. The non price determinants of demand are: income, buyer preference, price of substitutes, price of complement, price expectation, and number of buyers. In terms of income, the response of price depends on the type of good whether it is normal or inferior good, this paper assumes that oil is a normal good. The non price determinants of supply are: price of production factors, technology, number of producers, price expectation, and change in weather particularly for agriculture (Frank et al. 2009, pp. 74-77). While a change in quantity demanded and supplied will change the price along the demand and supply curve, a change in non price determinants will shift the demand and supply curve either to left or right depending on the circumstances. Shift right means quantity demanded or supplied is higher at any level of price, while shift left means at every price the quantity demanded or supplied is lower than before. In the market of one particular product such as oil, however, there will be only one price at one quantity level at a particular time; that is known as equilibrium price and quantity.

In addition to non price determinants, the price elasticity of the demand and supply curve will determine the magnitude of change in price and quantity. Price elasticity reflects the response of buyer (quantity demanded) and producer (quantity supplied) to a change in price for particular products (Frank et al. 2009, pp. 92). In the case of oil, although there is an indication that demand is elastic (The Economist 2008a), stronger evidence from an academic research shows that both oil demand and supply are price inelastic (Hamilton 2009, p. 218; Askari & Krichene 2010, p. 2013); that is what this paper will assume.

In this paper, the relationship between price (P) and demanded and supplied quantity (Q) of oil illustrated on supply (S) and demand (D) curve. The curves represent the global oil market situation during December 2008 to December 2010 where all (potential) buyers and sellers and other influencing actors have been interacting with each other. The curves assume that except oil price and relevant non-price determinants (which will be identified later), other factors that could affect the quantity demanded and supplied of oil stay the same (ceteris paribus).

The equilibrium price and quantity in the last quarter of 2008 was at E, which the price was US$54.8 per barrel (EIA 2010) at Q barrel per day. That situation is illustrated in diagram 1.

The average oil price and quantity during the first six months of 2009 fell because OPEC, which supplies around 40 per cent of world oil production, realized their intention to cut production. At the same time, the combination of the (then) current economic crisis and the growing environmental concern led to a decrease in oil demand (The Economist 2008a; The Economist 2008b; Musante 2009). The economic crisis decreased people's income, while environmental concerns had change people's preference and then consumed less petrol. This shifted the demand curve left (D'). The production cut by OPEC, because of price expectation (The Economist 2008b), shifted the supply curve left (S') which led to a new equilibrium at E'. It was where price was US$49.8 per barrel (EIA 2010) and quantity was Q' barrel per day. This change is illustrated in diagram 2.

The oil demand and supply during the last six months of 2009 was rose. The increase in demand happened because of the improvement in economy in the U.S. and China (The Economist 2009a). This increased people's income which led the demand curve shifted right (D''). Meanwhile, the supply side was relatively secured because of the sea (tanker) storage and OECD stock which was equal to 62 days of consumption. Other important factors were the fall in price of production costs and a new oil field in Saudi which will increase OPEC's spare capacity to about 8 per cent of oil world consumption (The Economist 2009a). This shifted the supply curve right (S") which led to a price increase to US$70.7 per barrel (EIA 2010) and a quantity increase to Q'' (a new equilibrium at E"). This change can be seen in diagram 3.

During all of 2010, the demand and supply of oil will keep increasing. The world economy will keep growing following the improvement of the U.S. economy (Businessweek 2010). The crisis in Greece will not spread because European Union member countries have agreed on 600 billion Euro loan (Toyer & Wissenbach 2010). This will increase global oil demand because the income of people will be increasing. As a result, the demand curve will shift right (D'''). Meanwhile, on supply side, there are two factors which will increase supply: the fall of production cost and failure of Copenhagen climate agreement (The Economist 2009b). These will shift the supply curve right (S"'). By the end of 2010, the new equilibrium will be at E"'. Oil price will reach US$83 per barrel at Q"' barrel per day. This can be seen in diagram 4.

In conclusion, oil price is determined by demanded and supplied quantity and non-price determinants. Both demand and supply of oil are price inelastic. While the increase of demand will increase the price significantly, there will be a smaller increase in quantity. This is because the magnitude of change in demand will greater than supply, and also because of the price inelastic. The increase of demand since mid 2009 happened mainly because of the improvement of world economy particularly in the U.S., after the global financial crisis. The increased of supply secured mainly because of the fall of production costs and additional production from the new oil field. This paper predicts that oil price will reach US$83 per barrel by the end of 2010.

References

Askari, H & Krichene, N 2010, ‘An oil demand and supply model incorporating monetary policy’, Energy, no. 35, pp. 2013-2021.

Businessweek 2010, ‘U.S. economy: unemployment unexpectedly falls to 9.7% (update3)’, Businessweek (online edition), 5 February, viewed 20 May 2010,

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EIA 2010, ‘Weekly all countries spot price FoB weighted by Estimated export volume (dollars per barrel)’, U.S. Energy Information Administration, viewed 20 May 2010, .

Frank, RH, Sarah, J & Bernanke, BS 2009, Principles of microeconomics, 2nd ed., McGraw-Hill Australia, North Ryde.

Hamilton, J 2009, ‘Causes and consequences of the oil shock of 2007-08/comments and discussion’, Brookings Papers on Economic Activity, no. 1, pp. 215-283.

Musante, K 2009, ‘Oil rises as OPEC cuts production’, money.cnn.com, viewed 20 May 2010, .

Nationmaster n.d., ’Energy statistics oil exports net(most recent) by country.” NationMaster.com. viewed 20 May 2010,

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OPEC n.d.,’Member countries’, OPEC.org, viewed 20 May 2010,

The Economist 2008a, ‘Down it goes’, The Economist.

The Economist 2008b, ‘Plumbing the depths’, The Economist.

The Economist 2009a, ’Meek oil’, The Economist.

The Economist 2009b, ’Oil to spare’, The Economist.

Toyer, J & Wissenbach, I 2010, ‘EU to fend off market "wolves" in Greek crisis’, Reuters, viewed 20 May 2010,

<http://www.reuters.com/article/idUSTRE6400PJ20100509>.