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The Oil Market And Economics 101

By A F Alhajji

I am writing this article out of frustration. How can I explain to my students the statements of OPEC oil ministers, energy officials in the oil consuming countries, petroleum analysts, commentators, and journalists that contradict the principles of economics?

First, “high” oil prices are not the result of “imbalance” between the supply of oil and the demand for oil. If we have a shortage, shouldn’t prices go even higher until the supply and demand are “balanced”? Isn’t the high price in this case the result of market equilibrium? If the market price of WTI is $70/B, does not that mean there is a buyer and a seller, or to use economics jargon, an intersection between supply and demand?

Second, analysts and journalists cannot speak of OPEC power and still use supply and demand to explain the oil market. Don’t they know that mixing “market power” with “supply and demand” violates the basic principles of economics 101? These mistakes are not limited to analysts and journalists. I know energy researchers who have published work in prestigious journals that violates such principles. In fact, I know economics professors who teach economics 101 who also fall in this trap. No wonder our views about the oil market are so confusing!

1. Shortage And Economic Principles

When there is a “clear imbalance between supply and demand,” as an OPEC document states, or “a fundamental imbalance between supply and demand growth,” as a senior official at a leading Canadian investment bank asserts, or “misalignment between supply and demand” as a well-known industry analyst declares, the oil market must be experiencing a serious shortage. A shortage exists when the quantity demanded exceeds quantity supplied. But hold on just a second. Have you heard of any shortage in the oil market? Have you heard of anyone who was willing and able to buy oil but could not find it? Haven’t you heard that Saudi Arabia offered its excess capacity of 2mn b/d of heavy crude but could not find buyers? Is this a shortage or a surplus?

Oh, sorry, you meant light crude. Fine. Have you heard of a single refinery that reduced its operations because it was willing and able to buy light crude, but could not get it? If a refinery cannot “afford” to buy, is this a shortage? How do you end up with a “shortage” when the buyer is not able to buy?

A shortage implies a gap between supply and demand that exists below market equilibrium. Therefore, prices have nowhere to go but up. Prices will continue to increase as long as there is a shortage, even if it is one barrel. Have prices continued to go up? Where is the “imbalance” then?

It was not a “shortage” that forced prices to go up last summer. It was not an “imbalance” between supply and demand. The oil market is not “static.” It is “dynamic.” Supply and demand keep shifting all the time, every minute of the day, which results in an equilibrium that necessitates a new price.

A disruption in the Nigerian oil exports reduces supply. The news of the disruption causes panic in the market and increases demand. This is a shift in the supply curve to the left and a shift in the demand curve to the right. The result is a higher equilibrium price.

The threat of a hurricane reduces supply and increases demand. Oil companies evacuate rigs and platforms and halt production. Refiners and traders, fearing “shortages”, buy more. Supply and demand shift, as indicated in the previous example. The result is an increase in oil prices.

Speculation and expectations affect demand and supply. If market participants expect higher prices tomorrow, prices will increase today. If they expect lower prices tomorrow, prices will decline today. All of those prices are “equilibrium” prices where supply intersects demand. Where is the imbalance?

Oil prices are the result of ever-evolving market realities that put supply and demand in perpetual motion—as long as we have a market for oil. To blame someone for higher prices, find out who has shifted demand or supply, don’t blame it on a “shortage” or an “imbalance.” Always remember your economics 101.

2. OPEC And Economic Principles

The objective of the following discussion is not to discuss whether OPEC is a cartel or not, a subject that has been covered extensively in the literature.1 The objective is to show that statements by a number of officials, analysts, experts, and journalists regarding the oil market do not have “economics merit.”

Economics 101: There is no market supply curve in a market that has suppliers with market power. Therefore, we cannot use the competitive supply-demand analysis to describe the market and at the same time describe OPEC as a “cartel.”

Economics 101: OPEC is not a monopoly. Monopoly is a market where the whole market is supplied by one producer. OPEC might be a cartel, but it cannot be a monopoly. The debate among experts is whether OPEC is an “oligopoly” or not. Oligopoly is a market with few producers where some of them exercise market power.

Economics 101: A monopolist (and an oligopolist) does not have a supply curve. A monopolist or an oligopolist operates at one point, but not on a curve.

Economics 101: OPEC is at its weakest point when it does not have excess capacity.

Economics 101: With excess marketable capacity, OPEC can influence oil prices when they are increasing, but it might not be able to influence prices when they are decreasing.

Finally, the relationship between OPEC’s excess capacity and market power should be studied with basic principles of Economics 101 in mind. Several studies that focused on the statistical analysis of OPEC behavior concluded that OPEC’s maximum market power was in the 1980s. But Economics 101 tells us that the market was highly competitive during that period. Statistical analyses are useless when they contradict economic principles. Having a data set and statistical software does not make people oil market experts.

Notes:

1. For details see Alhajji, A F & David Huettner "OPEC & Other Commodity Cartels: A Comparison" Energy Policy, Vol 28, No 15, 2000.

A F Alhajji, PhD, is an Energy Economist and Associate Professor at Ohio Northern University.The author can be reached via email a-alhajji@onu.edu. Petroleumworld not necessarily share these views.

Editor's Note: The preciding article was written for Middle East Economic Survey-MEES and published on 30-Oct-2006, VOL. XLIX, No 44. Petroleumworld reprint this article in the interest of our readers.

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Petroleumworld 11/12/06

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