Econ 101 for Oil

Many in the oil market seem to have forgotten Econ 101.  To bring everyone on the same page, below is meant to be a refresher in case you forgot, never learned or just didn't care.

First, a demand curve goes downward from a high price and a low quantity to a low price and a high quantity.  For example, at $15 a beer, you tend not to consume very many beers. But at 15 cents a beer, well......  

Supply curves are just the opposite.  They go from a low price and low quantity to a high price and high quantity.  So if you are making hot dogs at a food truck the price and the quantity would be:

If you can only sell hot dogs for 50 cents, you might  just stay home and sell zero.

But if you can sell hot dogs for $10, you are going to want to sell a zillion. 

If all of a sudden Costco has a sale on hot dogs and you can buy them for 10 cents each, then at every price you want to sell more hot dogs than before.  

For oil markets, the fracking/horiz/new technologies has meant that for every price, there is more oil.

Thus in the short-run (weeks), the following chart shows the impact:

But over time, things change. For example, at a low price most people will not buy a BIG car, fly more and in general use more oil. It takes time to schedule a vacation and buying a car is not done very week. But over several years, people will respond to low prices by increasing the quantity demanded at every price point. This is reflected in the charts below:

Notice how a price of $50 is required to clear the markets in the short-run, but a price of $90 is required in the long-run.  This basic difference is a reason commodity markets can be very volatile.

Prices can go up by 100% or down by 50% in a very short time. To clear a commodity market in the short-run, prices have to go crazy.

This is why farmers want various programs to stabilize the price of corn (or other products).  In oil, OPEC has preformed this role by increasing or decreasing production to stabilize the price. 

But when OPEC decides not to stabilize the price, the impact can be more severe than if OPEC did not exist. Many people planned on OPEC to provide stable prices and thus planned their actions on this assumption.   But when OPEC decides NOT to decrease supplies to stabilize price, the price needs to change more than normal and will stay lower longer than normal to cut production and stimulate demand.  

Last, but not least, is the question: How long is the short-run vs long-run?  When does the demand and supply curves change to less elastic curves?  This has been a question on the Investor Village Board BRY for the past week.  Some very good posters have argued that the supply and demand response would be fast, while others argue the supply response will take years.  How fast is the response?  Anyone who says they know for sure are wrong (even if in this case they lucky happen to be right).  

Many factors go into the response of consumers and producers to changes in price. 

1) The degree of price change.  Many books and articles have been written about the 'tipping point' where at some price consumers and producers 'wake up' and suddenly change behavior. Thus, many who use straight line response models, are shocked at sudden and strong movements by consumers and producers. 

2) Other economic factors.  For example, if the consumers just got a pay raise, they might behave differently than if they just got fired. Thus a strengthening economy (the US currently) is a far different response than a declining economy.  

3) Technological changes.  Producers may be experiencing such a great change in technology that the costs are falling even more than anyone expects.

4) Political concerns.  At a tipping point, both consumers and producers may be influenced by other factors, such as politics, geography and personal biases.  These are near impossible to predict and can make fools of many pundits. 

Given all these factors any estimation of oil prices in 2015, such as the price as of June 30 or Dec 31 is more of a guess than a scientific estimate. My personal view is the price could fall to some very low amount, but will rebound to $70s by June and $100 by Dec. But this is a wild ass guess and any price between $20 and $150 is possible.