The biggest topic in the global economy remains the oil price. It’s notoriously difficult to forecast commodity prices but how can we make sense of what would push the price up or down? A basic demand and supply framework gets us quite a long way
A market consists of demand, supply and some mechanism for setting prices. The crude oil market is one of the most global and most important. How can the price fall by more than 50% in six months, without anybody forecasting it? And how can we analyse what the price might be in future? I can’t offer a prediction but here are some ways to think about it.
Demand and supply can be captured in a simple diagram that sums all the market participants’ wilingness to buy (demand) or sell (supply) at each price. A market is in balance (“equilibrium”) if demand and supply are equal. The price that matches demand and supply is the market price.
So far, so obvious. This framework becomes more useful if we distinguish short and long run demand and supply. The concepts of short and long run go back to the Cambridge economist Alfred Marshall, who was one of the most important economists of his time (the last nineteenth and early twentieth century). His textbook Principles of Economics, written in 1890, was the standard one in British universities and was the one that Keynes studied.
Short and long run responses to price: elasticity
The short run is not a specific chronological period. It means a period when agents can make few adjustments to their costs or procedures. So in the short run I have a particular car and house heating system which commit me to a particular choice of fuel and energy efficiency. If the price of oil or gas rises I will be limited in my scope for changing behaviour so I may not buy much less than before, even though I’m unhappy about the higher price. This means that the short run price elasticity (the sensitivity of demand to a change in price) is quite low. This is equivalent to a steeply sloped demand curve.
But in the long run I can buy a more fuel efficient car (and cars become more efficienty partly to reflect increasing demand for fuel efficiency but also because governments set increasingly tough efficiency targets). And I can buy a house with a different type of central heating system or get the house insulated (these are admittedly less easy to do, which is why buildings are the most intractable area of energy efficiency improvement).
My price elasticity is much higher in the long run because I can make more changes than in the short run. The demand curves is therefor less steeply sloped in the long run. The same is true of supply, which captures the behaviour of producers.
Consider the effect of a fall in oil prices on suppliers. In the short run, though it hurts profits, producers will rationally keep producing until the cash income from production is less than marginal cost of production. Even if the business is making an accounting profit loss it is better off covering at least variable costs, rather than shutting down altogether. The variable costs of different types of oil vary enormously from about a few dollars a barrel in Saudi Arabia to $60 or more in US unconvential (“shale”) oil (see chart below).
So the price elasticity of supply is quite low in the short term. But the producers will make other decisions that affect long term supply. We are hearing daily about the cancellation of new investments into oil exploration and production that are not likely to be profitable unless prices rise a lot. The oil companies have to make decisions over decades to come so they can’t scrap all new investment. But they have to revise down their long term price expectations to some extent.
The oil market supply reaction is still in the short run
Putting all this together means there is a short term market price equilibrium which reflects the big rise in supply in the last year, mainly from the US, Libya and Iraq, combined with a somewhat lower than previously expected level of demand, because the world economy is growing less fast than expected (but probably still faster than it was in 2013 and 2014). That price is currently about $50 for Brent crude. There are lots of oil producers, especially in the US, which are covering their variable costs at that price but not their fixed costs. So they are making an accounting loss and will not be investing in any new production unless they are confident the price will rise again.
The lower cost producers such as the onshore Middle East are still profitable at the current price, though they are suffering a big loss of income compared with what they made a year ago. They are not going to change production and they will probably keep investing, since even the newer fields in the Middle East are still profitable at current levels.
Offshore investment, especially deep water, is much more questionable an investment at current prices. Some projects are already committed (a lot of investment has already taken place and the companies are reluctant to write it off, even though economic logic says these costs are largely sunk so they should be irrelevant to future decisions). But many others that would have proceeded at higher oil prices will now be postponed.
Those decisions amount to the long term supply reponse. The volume of oil that is profitable (including covering fixed costs) at $50 is likely to be lower than the current amount being produced. If new investment falls and the older wells gradually run out (especially in US shale where the depletion rate is much faster than in conventional oil) then global supply will fall.
Demand will keep rising so long as rising incomes (“the new global middle class”) lead to rising energy demand, especially for cars and trucks. If governments are smart enough to remove subsidies and even push up carbon-based taxes then the price to the consumer will not fall that much. But underlying global demand is likely to keep rising for many years to come.
Lots of current production may not be profitable at current prices
At some future price, higher than at present, long run demand and long run supply will be balanced and the oil market will find a new equilibrium. I don’t know what that is but if you had all the data on demand and supply you could at least come up with a sensible estimate. For the supply side, here is an interesting chart from a new IMF working paper, estimating the break even price for different types of oil supply. It shows the price of oil on the vertical axis and the supply, ranked from lowest cost to highest along the horizontal axis with an estimated break even price for each category. So oil sands, the type of oil found particularly in Canada, have a breakeven price of $88. These supplies will eventually dwindle, with no investment in new capacity, if prices remain close to current levels.
If this chart is correct then around half of current oil supply is not profitable at $50/barrel. So if the short run lasts a year or so then the price can remain about $50. But it cannot stay at that level indefinitely because the long run supply curve of oil doesn’t intersect the long run demand curve at that price. The price at which it does intersect is very important but hard to estimate.
Some long term perspective on commodity cycles from Carmen Reinhart. The current commodity price bust is very much in line with history it seems.
An IMF model of oil price forecasts using purely statistical analysis.