Understanding Crude Oil Prices - Essay Example

The trends witnessed in Europe with regards to prices of crude oil can be to a large extent associated with the simple rules of demand and supply. As the quantity of crude oil produced becomes less in comparison to what is demanded, then the law of demand acts in a manner that prices shoot up. At the same point in time, due to the high levels of crude oil demanded, producers raise their levels of production so as to maximise on the returns being derived from the sales of crude oil. Below is a graphical illustration of the behaviour of demand and supply. Graph 1: illustration of the general relationship between demand, supply and prices Prices ($) Supply p2 p1 p2* Demand Q1 Q2 Quantity of crude oil (barrels) As can be seen from the graph, at price p2 quantity Q2 is supplied, while at price p1 quantity Q1 is supplied. Obviously, from the graphical illustration, more is supplied while prices are higher than when they are low. Looking at the demand curve, on the other hand, while prices are high at p1, then quantity demanded is low at Q1. This is unlike the case where prices are lower at p2*, at which the quantity demanded rises to Q2. (investopedia.com, 2011) Some of demand factors as well as supply may have an impact in the short-term while others will be experienced over the long-term. The latest oil price shock has been majorly attached to the demand factors as the driving force especially between the year 2004 and 2008. (Hamilton, 2008) In the short-run there are two experiences that are evident; higher demand levels and an inelastic supply curve. This in turn causes a price upsurge as far as oil is concerned. The reasoning behind this is that as demand escalates, a decline in the stocks of oil is experienced worldwide, in all main oil refineries in the globe. The prices of oil are then forced upwards. This gives a message to the suppliers of oil in the globe to grow their production. However, a hindrance arises since it is not possible to make some extra stock supplies in the short-run. Thus, there will be an escalation of prices as demand shifts against an inelastic supply in the short-run. As one can observe from the following graph, in the short-run some factors of supply can be varied and this leads to an increase in quantity of oil supplied. However, some of the factors that can lead to a further increase are not varied in the short-run, which causes a totally inelastic supply curve at a given point. For a better illustration to this theory, the graph below is of great essence; Graph 2: An illustration of an inelastic supply curve in the short-run and shifts in demand that lead to a rise in prices worldwide Price in $ Supply P3 P1 Demand (D3) Demand (D2) Demand (D1) Quantity of oil in barrels Demand of oil may shift (increase) from D1 to D2 and then to D3. At the same time, prices may remain at P1 due to the fact that there is enough supply until a certain point where supply cannot be varied and this forces price to rise to price P3. There are some factors that are witnessed to impact on the prices of crude oil in the short-run and having a run through them would be of great essence in trying to understand the situation in the short-run. Some of these factors are with the inclusion of; Spare capacity- This refers to the amount of spare production in the sector of oil. Stock- These are the levels of stocks of crude oil that are available in the current times and which can satisfy the immediate demand requests from the main oil refineries. A bigger stock level would mean that it is quite possible to satisfy the demand needs shown in the short-run. Profit motives- This may refer to the objectives of production as set by both OPEC and Non-OPEC nations. External shocks- These impact on the production levels. Major examples of things that might cause shocks are terrorist attacks and war as far as oil producing nations are concerned. (tutor2u.net, 2011) In the long-run, many of the factors of production may be varied and thus, a generally elastic supply is evident. Thus, prices may not rise at a relatively great extent as was witnessed in the short-run case. Therefore, in the long-run as demand increases, the supply also increases leaving consumers at a better position since prices may not escalate to unmanageable levels. The situation in the long-run may be illustrated below in a graphical presentation. Graph3: A graphical illustration of a relatively elastic supply curve in the long-run Price in $ Supply P3 P1 Demand (D3) Demand (D2) Demand (D1) Quantity of oil in barrels The graph shows a shift in demand (which is a rise from D1 to D2 and then to D3) in the long-run. At the same time the supply curve remains relatively elastic and thus, the resultant change in prices is a slight increase from P1 to P3. This illustrates the fact that some factors of production that are not variable in the short-run scenario can be varied in the long-run, which causes the relatively elastic supply curve. Therefore, prices may not have a great upsurge, in the long-run, as was witnessed in the short-run illustration. On the other hand, and as mentioned earlier in the study, some of the factors may only be witnessed to affect crude oil supplies in the long-run. Examples of the long-run factors are as follows: Technology- These are technological variances that can be effected in the extraction of oil. These are, basically, the factors that may impact on the profitability and costs of oil extraction and refining. Exploration- This refers to the investment expenditure upon the exploration, the subsequent identification, and lastly, the exploitation of reserves of oil. If prices of oil are witnessed to have a continuous ascending in the recent times, then it is quite in order for nations to make investments towards oil exploration. Reserves- At this point, it is notable that as demand rises, the more rapid the rate of depletion of oil reserves. Some of demand factors are as well important to mention. Demand for oil is seen to be under the influence of various factors. These factors are as enlisted under Substitutes’ prices- The demand for crude oil is quite dependent upon the price of its substitutes. One of the substitutes is gas. Shifts in demand leftwards, (decrease) may be witnessed if over the long-run discoveries are made with regards to crude oil substitutes. This is especially if the discovered substitute is a reliable one. Cyclical Demand- As the global economy grows; there is a very strong relationship with demand for crude oil. This is due to the high demand levels in energy-intensive industries. Increases in demand will always be witnessed as various economies expand and call for more crude oil supplies like in the recent case of China. Variance in Climate- Heating oil is usually under very high demand when nations in North America and Europe are in the winter season. Market Speculations- If it is speculated that in the near future, there will be an upsurge of prices of crude oil due to scarcity. Then, there will be a triggering of an increased demand of oil in the times just before the speculated. (tutor2u.net, 2011) Reference list: Hamilton, J. (2008). Understanding Crude Oil Prices. Working Paper 14492. National Bureau of Economic Research. investopedia.com. (2011). Economics Basics: Demand and Supply. Retrieved 5 December 2011 http://www.investopedia.com/university/economics/economics3.asp#axzz1fbzWmaCC tutor2u.net. (2011). Market for Oil. Retrieved 5 December 2011 http://tutor2u.net/economics/revision-notes/as-markets-oil.html Read More