Supply and Demand of Oil

Question: Write an essay on supply and demand of oil. Answer: (a) The price of oil depends on the supply and demand as well as on price expectations. There is more than one reason behind the continued fall in oil price ever since 2014. The consumption of oil has not decreased. However, the demand for oil has declined on the global forum over the years. One reason is that economic activities have become slower in some of the oil-importing countries like China. Moreover, America, which earlier used to be a major oil-importer in the international market has started its own oil production and by a huge scale. This has led to a fall in the international demand for oil and also an increase in the international supply because when America ceased or decreased its oil imports it generated a spare supply of oil in the international market and oil inventory is accumulating for the oil-exporting countries. The effects on the international oil market can be shown with the help of the following diagrams: (i) The supply increases exactly as much as the demand falls. In Fig. A.1, the increase in supply equals the fall in demand for oil. As a consequence of this, the equilibrium quantity of oil remains the same at Q* whereas the equilibrium price falls from P* to P. (ii) The increase in supply is less than the fall in demand. When the fall in demand exceeds the rise in supply, the equilibrium quantity falls from Q* to Q and the equilibrium price also falls from P* to P as shown in Fig. A.2. (iii) When the increase in supply exceeds the fall in demand. In Fig. A.3, the supply increases more than the fall in demand. Hence the equilibrium quantity increases from Q* to Q. However, the price falls from P* to P. Thus, the equilibrium quantity of oil adjusts according to the relative positions of the demand and supply curves. However, in all the cases, irrespective of the movements in demand and supply, the price of oil rises. This explains why the price of oil has continued to fall. However, Fig. A.1 shows the situation when the consumption of oil has not increased substantially (or at all in this case). (b) When oil prices fall, oil-importing countries generally benefit whereas oil-exporting countries lose out. (i) For the huge oil-importing countries such as China or India, the fall in the international price of oil is beneficial. The price elasticity of demand for oil is relatively inelastic. This implies that when oil prices change, the demand for oil changes less than proportionately. Hence, when oil prices drop, demand remaining more or less the same, the import bill of oil-importing countries falls. This frees up money for domestic consumption. Thus, demand for domestic production increases. Since imports constitute a negative component of the GDP, a fall in the import bill naturally boosts up the GDP of an economy leading to further economic growth. Falling oil prices translating into falling import bills, eases the current account deficits of oil-importing countries and increases their long-run growth potential. China, being the largest oil importer in the world benefits in a lot of ways from falling oil prices. It generates current account surplus and augments the GDP of the country. In addition to that, tax and fiscal systems can be reformed to increase the efficiency of the economy. However, on the negative side, falling oil prices can lead to deflation and a fall in investment on domestic energy supplies. Nearly 8% of the oil used by the Indian economy is imported. Falling oil prices leading to a fall in the import bill of the country affects it in different ways. The positive impacts are that current account deficit is narrowed down and inflation rate falls. However, this may have adverse effects on petroleum producers of India who export petroleum in the international market. (ii) A fall in oil prices adversely affects the huge oil-exporting countries like Saudi Arabia or Iran. Given that the demand for oil is price inelastic, a fall in the price of oil does not increase the demand for oil adequately, that is, even if the demand for oil increases, the increase is less than proportionate to the fall in price. Thus, the export bill of the oil-exporting economies falls on the whole. In the GDP, exports constitute a positive component. Hence, when the export bill falls, the GDP of the economy is negatively affected. This reduces the growth potential of the economy. The biggest oil exporter in the world, Saudi Arabia, has not cut down on the production of oil in spite of the falling oil prices. This has led to considerable deterioration in the financial condition of the economy because costs of production have not reduced. Moreover, the economy has become vulnerable to the volatility of oil prices since oil exports add to the fiscal revenue being the primary production of the economy. Though Iran is a relatively smaller exporter of oil, yet the same impacts have fallen on Iran because oil revenue constitutes a major part of the GDP of the country. (iii) For countries like USA or Indonesia who have a huge amount of oil of their own but also cater to a huge domestic market, the impact of the falling oil prices on the domestic economy can be manifold. As international oil prices fall, domestic prices will also have to be reduced to the same level because of potential competition. This hurts the domestic oil producers as by reducing their revenue to a considerable extent. However, if some part of the total oil consumption is imported that import bill will fall with falling oil prices. The effect on the economy as a whole is somewhat ambiguous. The increasing oil production in USA is the primary reason why international oil prices began falling in the first place. (c) (i) Industries that use oil or other oil products as inputs to production will gain from falling oil prices. Falling oil prices translate into falling costs of production in the retail industry thereby boosting growth. Lower oil prices leading to lower gas and petroleum prices will benefit the transportation industry by reducing fuel costs. Again, the demand for automobiles will also increase over the long run because of a fall in the price of petrol and diesel arising out of a fall in the price of oil. This provides a demand boost to the automobile industry. (ii) For the oil industry as a whole falling oil prices will lead to major losses. Moreover, the diesel and petroleum producing countries will also lose out from low oil prices translating into falling fuel prices. The gas industry also incurs losses. However, when oil prices fall, it leads to a general deflation in the economy, that is, the overall price level falls. This may affect many industries adversely. References Mankiw, N 2006, Principles of microeconomics, Cengage Learning, Boston. Pindyck, R and Rubinfeld, D 2004, Microeconomics, Prentice Hall, USA. Varian, H 2005, Intermediate microeconomics: a modern approach, W.W. Norton Company, New York. economist.com 2014, Sheikh v shale, viewed 26 May 2016, economist.com 2016, Whos afraid of cheap oil? , viewed 26 May 2016, economist.com 2014, Why the oil price is falling, viewed 26 May 2016, theweek.co.uk 2016, Has oil hit a sweet spot for the global economy? , viewed 26 May 2016, Bowler, T 2015, Fall in oil prices: Who are the winners and losers? , viewed 26 May 2016.