Oil Markets

The global oil market is the most important of the world energy markets because of oil’s dominant role as an energy source. Understanding how it works will also shed light on the functioning of energy markets more generally. What does it mean to say that there is a global market in energy? Fundamentally, oil is a commodity, and contracts for its supply are usually traded through commodity exchanges such as the New York Mercantile Exchange and the Intercontinental Exchange. ¹

How much does a barrel of oil cost? What does it mean when newspapers report that oil is selling for $75 per barrel? Such numbers are often cited in discussions of energy policy, yet they fail to convey the complexity of global oil markets. Because it is impossible to synthesize the diversity of oil prices around the world, economists usually refer to benchmarks, a small number of carefully tracked prices that are considered industry standards and against which all other prices can be compared. For oil, the two most common benchmarks are Brent Crude and West Texas Intermediate. Brent Crude is oil “sourced” from the North Sea and is the benchmark against which prices are set for oil coming from Europe, Africa and the Middle East.2 West Texas Intermediate is the price used for contracts traded on the New York Mercantile Exchange and is typically the price that the media has in mind in reports about oil 3.

Markets are designed to allocate efficiently resources between those who supply and those who demand a particular product. There are two economic concepts that are important to understanding how supply and demand function in global energy markets: the marginal unit and elasticity.

Marginal Unit and Price

Let’s say a company is currently producing 100 barrels of oil. As the company decides whether to pump out more oil from its stores, it will weigh whether each additional unit of production will be profitable. Each unit that is additional to current production is a marginal unit; the cost of producing this unit is known as the marginal cost, and the price at which it can be sold is the marginal price. What happens at the margins is important because it largely determines the behavior of producers and consumers, thus shaping the market. This principle holds true for all tradable commodities, including oil. ⁴

In a globalized world where most countries are heavily dependent on a host of foreign suppliers to satisfy their demand for energy and where suppliers are already operating at peak capacity, the marginal unit of production might come from anywhere in the world. Globalization has, to borrow a phrase from New York Times columnist Thomas Friedman, “flattened” the world, such that the actions of minor oil exporters distant and often unstable countries such Nigeria, Sudan and Iraq can affect the price paid for a gallon of gasoline by consumers in every oil-importing nation.⁵ Many advanced economies find these developments destabilizing and therefore threatening. It does not matter where or by whom a barrel of oil is bought or sold: the marginal impact of this transaction will echo around the world. In the end:

No private oil company will sell oil to its domestic market for one penny less than it could realize in foreign markets, and the price that a barrel of oil commands will be based on pressures beyond any one government’s control. ⁶

Because of the influence commanded by the marginal unit, sovereign nations do not have much control over the price of energy. Claims by national governments that energy independence will provide such control are emptier than they might first appear. According to Washington Post columnist Sebastian Mallaby, “Because oil is traded globally, a supply disruption anywhere will affect gas prices” throughout the world. It follows from this analysis that “there’s no use thinking nationalistically.” ⁷ Exemplary of this for American citizens are the wars in Iraq and Afghanistan that have created an almost continual rise in the price of oil coming from that area.

The tightness of energy markets in recent years, which stems from high demand and relatively stable supply (see sections on “Oil Demand” and “Oil Supply”), means there is even less room for a disruption in global supplies:

In a world where every single barrel counts, the actions of Chad’s president could threaten global energy security…Because the world is pumping at just about full capacity, the global oil market cannot afford the loss of exports from even the smallest producer. ⁸

In today’s market, every marginal producer has “unprecedented power and greater geopolitical influence” than ever before. ⁹ This is one of the reasons why energy issues continue to become more prominent in debates about everything from national economic policies to international diplomacy.

Elasticity

Elasticity is the measurement of how responsive supply and demand are to fluctuations in price. The supply or demand of a good is considered relatively inelastic when price does not have a large effect on production or consumption, respectively. If price does have a significant effect, then the good’s supply and demand are called elastic. If you have difficulty thinking of elasticity in the abstract, imagine a rubber band: if it is easy to stretch and thus responsive to force, it is elastic.

Elasticity is largely determined by the availability of substitutes. If, for example, the price of coffee rose from $1 per pound to $1.10 per pound, consumers who are sensitive to price considerations might switch to tea. If many consumers are willing to switch based on such a relatively small change in price, then the demand for coffee is regarded by economists as “elastic.”¹⁰ If, on the other hand, a 10¢ increase in the price of a pound of coffee did not cause consumers to start buying tea instead, then demand would be “inelastic.” For many forms of energy, such as oil, substitutes are not readily or cheaply available. Demand for oil is thus thought to be generally inelastic, requiring deeper structural changes to impact demand.

There have been many debates about the elasticity of energy supply and demand. A surprising trend to emerge in recent years has been the seeming inelasticity of demand in the face of extremely high energy prices. One way to explain this inelasticity is to take a closer look at the factors driving high prices. Previous price spikes, such as those that occurred during the oil crisis of the late 1970s (see section on “Oil Supply II: Producers” ), were caused by restrictions to global energy supplies, i.e. they were largely driven by supply factors.

In the present oil market, however, high prices are largely a function of record demand, much of which can be attributed to the rise of an energy-hungry China. Because the current situation is demand driven, high prices have not triggered corresponding decreases in consumption. This leads many to believe that the days of cheap energy are over and that expensive energy is here to stay.

Others contend that the elasticity of demand will gradually manifest itself. According to one experienced observer:

For years, [economists] thought that petroleum consumption was inelastic and impervious to price fluctuations, only to discover later that this was not the case. In fact, price always affects demand, even if the connection takes time to manifest itself, as consumers try to maintain the lifestyle they are used to for as long as possible. ¹¹

Consumption patterns will eventually adjust themselves to account for higher global prices. Such an adjustment may already be occurring, as oil prices have begun to moderate. In response, OPEC has announced yearly cuts in production. The most recent cut for 2009 was announced at the end of December.  OPEC countries pledged to cut 2 million barrels a day to ensure against more price drops in a difficult economy.¹² To give this figure some perspective: world demand for oil was 80 million barrels a day in 2003 and has increased slightly to 83.3 millions barrels/day in 2009. ¹³ Many future policy decisions will depend on how the question of elasticity is viewed.

1 Mouawad and Timmons
2  “Oil Markets Explained”
3 “Oil in Troubled Waters;” “Oil Markets Explained”
4 Wirth et al.
5 Friedman, The World Is Flat
6 Deutch
7 Mallaby, “What ‘Energy Security’ Really Means”
8 Mouawad, “Kings of the Oil World”
9 ibid.
10 “Economics Basics: Elasticity”
11 Maugeri.
12 Mustanti.
13 International Energy Outlook 2006 25