Crude Oil - price elasticity of supply

[GliderGuider]

The recent thread Crude Oil to surpass $150 per barrel got me thinking about the recent behaviour of oil supply vs price, so I decided to investigate it a little further. Using data from the EIA and IndexMundi I graphed the monthly world and OPEC oil production and average monthly oil price for the last 10 years. I got this:



The first thing that jumps out at me from the graph is that the world’s oil supply really has been on a plateau since at least January, 2005. In that time world production has only varied +/- 2% from 73 mbpd. In the same period, OPEC’s output has varied +/- 5%. This shows that OPEC has more ability to increase and decrease production that the world as a whole, which is no great surprise. What is surprising that over that period OPECs production has only gone up 0.3%, while world output has risen 1.25%.

Then I calculated the price elasticity of supply (PES) for the world as a whole and OPEC alone, over three periods. The first period is Jan. 2002 to Jan. 2006, and the next is Jan. 2006 to Oct. 2010. This shows the change in the ability of OPEC and the world producers in general to respond to price changes, roughly in the period before the supply hit the plateau and the period since the plateau began. Then I calculated the PES for the period of the price spike, from Jan. 2007 to July 2008.

The values came out like this:

Period      World   OPEC
2002-2006    0.05   0.09
2006-2010    0.02  -0.03
2007-2008    0.01   0.04

The first thing that's obvious that the oil supply is remarkably inelastic. I think this is what makes it so sensitive to market manipulation – price and supply can get disconnected very easily, as happened during the 07-08 spike.

The second thing is the dramatic change from the period before 2006 to the period since then. The ability of the world’s oil producers to respond to price changes has been cut in half, and OPEC appears to have lost this ability entirely.

During the price spike the world as a whole did not really respond to the rise in prices (in fact ex-OPEC production declined by 2% during that period), and OPEC responded only half as vigorously as during the normal times leading up to it. Part of the reason for this is that it takes longer than a year and a half to put really new supplies on-line, but it also shows that the spare capacity that OPEC touts simply isn't there. Saudi Arabia is no longer a swing producer.

All in all, this is a picture of the world at Peak Oil. Producers are struggling to respond to price signals, and their ability to do so is declining over time. Since 2006 no price movements have resulted in a significant supply change, whether the price change was extreme (2007-2008) or relatively gradual (2006-2010). Both OPEC and the rest of the world are showing undeniable signs of exhaustion.

This situation makes the world extraordinarily vulnerable to price spikes brought on by any of a number of factors, whether they are local supply disruptions, speculation and market manipulation, or geopolitical concerns. We face a bumpy ride in the oil sector from now on.

[safeinOhio]

1. speculation and market manipulation

Make speculators have the ability to take delivery. Airlines, farmers and trucking need to be able to have the ability to level price hikes. Speculators are gamblers that just drive the price up or down on bets.

[GliderGuider]

2. Sharp price moves are uncomfortable for everyone

However, what worries me a lot more is that producers have lost the ability to respond to any prices moves at all, whether legitimately demand-based or manipulated.

Regulations of one sort or another on speculators would help smooth out the price curve, but we have a much bigger problem on our hands than just the price.

[Yo_Mama]

3. Yes, it is inelastic, but not over the longer run

What happens is that if prices get too high, it takes down economies.

Also, the huge spike in price in 08 was due to speculation, not consumption. That was sparked and inflamed by idiotic price projections from WS sources that had money in the deal. And the global economic crisis had a lot to do with oil prices. Incomes are varying inversely with the price of oil, and in the long run, incomes determine business profits and investment.

It takes years to bring major new supplies into production, and no one wants to put the money into it until they are sure that when they complete the investment, they will be able to sell the product at a profit. So there is a slow supply/price response, but it is there.

Note that OPEC's genuine drop in production didn't do much to offset what was then a genuine global glut of oil and the consequent steep drop in prices.

[GliderGuider]

4. Distinguish elasticity of demand from elasticity of supply

Falling of economies reduces demand, which is one of the effects we're seeing right now. Demand for oil is quite a bit more elastic than supply.

I agree that there is a long-term supply response to price, but what I noticed is that is seems to be getting more anemic over time.

I also agree that the 2008 spike was due to speculation, however if the supply was more elastic that wouldn't have been possible (or at least not as severe) - an increase in supply could have balanced the price, but only if there was in fact the spare capacity Saudi Arabia always assured us was available.

Net oil exports have been falling for three years, down now about 6.5% from 2005/2006 (the moment we hit the production plateau) to the end of 2009. The market is tightening relentlessly.

[Yo_Mama]

5. It's a minimum of 3-4 years for a major project.

One of the big sources of new supply are the synthetics from Canada. Several projects were put on hold when prices crashed.

No one's going to put significant funds into Venezuela - they have resources but until trust in the government develops they won't be developed.

Underwater drilling rigs are working as fast as they can go. They will continue to open up new supply, but there is a limitation as to how fast.

And then there are the heavier byproducts of natural gas, which are adding a percent or two to US production and some around the world, I think.

If prices average over 65 for four years I think more resources will go into opening up new production.

Edit to include link to NY Times article from 2008:
http://www.nytimes.com/2008/12/16/business/16oil.html

[westerebus]

6. Hey GG are Iraq's numbers in this?

Are they in OPEC or off the farm now that they have been liberated?

[GliderGuider]

8. Yes Iraq is included. And they're still in OPEC. nt

[appal_jack]

7. k&r

This is worth thinking-over, and then making the best preparations that one might...

-app