2.9 - Case Study: Demand & Supply of Oil
The importance of oil in the economy
Oil serves as a fundamental commodity that underpins much of global economic activity. It is essential for manufacturing a wide range of products and is heavily relied upon for transport systems worldwide.
Economic effects of oil price changes
- Inflationary pressures - Rising oil prices can drive up the cost of goods and transport, leading to higher overall prices in the economy.
- Mitigating factors - Advances in energy efficiency and declines in certain industrial activities can lessen the effects of oil price fluctuations.
- Price volatility - Oil prices experience significant swings, with sharp rises and falls occurring over short periods.
Factors influencing demand for oil
Demand for oil is shaped by a variety of economic, social, and environmental elements that affect how much is needed globally.
Key influences on oil demand
- Global economic conditions - Demand rises during periods of economic expansion when production and consumption increase, but it drops in recessions as activity slows.
- Speculative trading - Traders who buy and sell oil to capitalise on price movements can boost or reduce demand.
- US dollar strength - Since oil is traded in US dollars, a stronger dollar can make it more expensive for buyers using other currencies, potentially lowering demand.
- Derived demand from oil-based products - Greater need for items produced from crude oil, such as plastics or fuels, increases the overall demand for oil.
- Availability of alternatives - If substitutes like renewable energy sources become more affordable, dependable, and accessible, demand for oil decreases.
- Weather patterns - In major oil-consuming nations, harsh cold weather boosts demand for heating and energy.
- Improving living standards - As incomes rise, people consume more goods and services that rely on oil, such as larger homes and personal vehicles.
- Growth in emerging markets - Rapid development in these economies pushes up global demand by shifting the demand curve to the right.
Factors influencing supply of oil
Supply of oil is determined by production capabilities, geopolitical events, and technological advancements that affect how much can be brought to market.
Key influences on oil supply
- Geopolitical disruptions - Conflicts or instability in key oil-producing areas can interrupt output, causing supply shortages and price spikes.
- OPEC's role - The Organisation of the Petroleum Exporting Countries (OPEC) significantly controls global supply by coordinating production cuts or increases among member nations to influence prices.
- Reserve levels - The scale of untapped oil reserves impacts long-term supply potential, with larger reserves enabling greater future output.
- Extraction expenses - High costs can make some reserves uneconomical to develop until prices rise enough to justify the investment.
- Technological progress - Improvements in drilling and refining methods reduce costs and boost efficiency, increasing supply by shifting the supply curve to the right.
- Production strategies - Producers may hold back reserves or stockpile oil to avoid flooding the market and driving down prices.
- Delays in supply adjustments - Expanding production takes time due to the lengthy processes involved in exploration and development.
Inelasticity of demand and supply for oil
Both demand and supply for oil exhibit price inelasticity, meaning changes in price lead to relatively small shifts in quantity.
Characteristics of inelastic demand and supply
- Price inelastic demand - A rise or fall in oil prices results in only a minor change in the amount demanded, as alternatives are limited and oil is essential for many activities.
- Price inelastic supply - Supply does not respond quickly to price changes because increasing production requires significant time for new exploration and infrastructure.
- Short-run effects - Due to these inelasticities, even small shifts in demand or supply can cause large price fluctuations, with limited changes in quantity.
Impacts of changes in oil prices
Shifts in oil prices have wide-reaching consequences for businesses, consumers, and the broader economy, often triggered by movements in demand or supply curves.
Effects of supply and demand shifts
- Supply reductions - Events like supply-side shocks cause the supply curve to shift left, raising prices and reducing quantity demanded.
- Demand increases - Rightward shifts in demand, such as from emerging economy growth, elevate prices, prompting producers to ramp up output, though with delays.
- Supply expansions - Advances in extraction technology shift the supply curve right, lowering prices, with inelastic demand amplifying the price drop more than the quantity rise.
- Business cost implications - Higher oil prices increase expenses for firms reliant on oil, which may lead them to pass on costs through higher prices for their goods.
- Limitations of alternatives - Some new extraction methods do not fully replace traditional crude oil, restricting their ability to stabilise global prices.
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