Oil Supply and Demand. Student s Name. Institution Affiliation. Course. Date

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1 Running Head: SUPPLY AND DEMAND Oil Supply and Demand Student s Name Institution Affiliation Course Date

2 SUPPLY AND DEMAND 2 Article Summary The article discusses the recent oil price fluctuations and the reaction of competitors within the industry. Even though political factors have played a role in the collapse of oil prices the forces of demand and supply have been the key factors determining the prices. Organization of Petroleum Exporting Countries (OPEC) has been at the forefront in the fight for market share by using the forces of supply and demand. The country members of this organization produce a third of all the world s oil and have been worst affected by the sharp drop in oil prices since late 2014 (Lawler, 2015). However, these countries are using the sharp decrease in prices to increase their market share and to push out higher cost non-opec producers. Introduction This paper focuses on the microeconomic theory to explain the price movements as well as the competitors actions. It will analyze the effect of supply and demand forces in the oil market. The price elasticity of demand for oil will also be analyzed and finally the market efficiency in the oil industry.

3 SUPPLY AND DEMAND 3 Article Analysis Demand and Price The law of demand states that as the price of a good or service increase, the demand for it decreases and, when the price of a good or service decrease, the demand for that product or service increases (Price, 2013). This means that price and demand have an inverse relationship. For example, if there is an escalation in oil prices, the demand for it decreases since fewer people can afford to fuel their vehicles. Industries will at the same time limit their usage of oil in an effort to save on the cost of production. Conversely, a decrease in the prices of oil will consequently lead to a significant increase for its demand as more people will afford to fuel their cars. There would also be increased demand due to the actions of speculators who would buy it in bulk to protect themselves from future increase in price. Figure 1: Demand Curve Movement for Oil Price ($ per Barrel) Quantity Demanded (Million Barrels per Day)

4 SUPPLY AND DEMAND 4 The figure shows the movement of demand for oil due to a change in price. As the price of oil decreases from 100$ to 60$ the demand for oil increases from 20bpd to 30bpd. Supply and Price An escalation in the price of a good or a service will subsequently cause an increase in the supply of that product and, as the price of good or service decreases, the supply of that product also decreases (Price, 2013). Price and supply have a positive correlation for most goods and services. For instance, as the price of oil increases, more oil is produced as oil producers seek to maximize their revenues. Conversely, as the price of oil decreases, the supply of oil also decreases. This is because; most producers would be looking to cut on the cost of production while still retaining their market share. However, this rule does not always apply since some low-cost producers take this opportunity to gain more market share from higher cost producers. Figure 2: Supply Curve Price ($ per Barrel) 100 S1 S Quantity Supplied (Million Barrels per Day

5 SUPPLY AND DEMAND 5 The figure shows that a change in price from $100 to $60 the supply for oil also reduces from 35bpd to 19bpd. This is a figure for non-opec countries whose production cost are relatively higher compared to OPEC countries. In the case of oil products, there is competition for the market share that has prompted the producers to use their competitive advantage. OPEC countries have increased the quantity supplied even as the price of oil remains low. This has caused a shift in the supply curve of oil as they seek to increase their market share in the long run. From figure 2, the supply curve shifts to the right showing that producers are willing to supply more oil at a low cost. In this case, the OPEC countries have increased the quantity they are supplying at a price of $60 from 19bpd to 29bpd. This has caused a shift in the supply curve from S1 to S2. Price Elasticity of Oil Price elasticity is the degree of the sensitivity of demand due to price changes. It is derived by dividing the percentage change in quantity demanded by the percentage change in the price of a commodity. Oil is one of the essential commodities in today s technologically advanced world. It is used in manufacturing, fueling cars and fuelling airplanes among other things. From figure 1, the price of oil is elastic; a fall by 40% in price causes an increase of 50% in quantity demanded. This means that demand for oil is highly sensitive to the price of oil. A small change in price is bound to have an even bigger impact on the quantity demanded. OPEC countries have realized this and have increased their production significantly to cover for this

6 SUPPLY AND DEMAND 6 high increase in the quantity of oil demanded. In most cases, the increased demand arises from the creation of a new market. This elasticity means that overall; all oil producers are gaining more revenue from the increased demand for oil due to the decreased price. However, this has ended up reducing the net profit of oil producers due to the cost associated with the production of oil (Rapaport, n.d.). The net profit margin per barrel has reduced significantly, and there isn t enough demand at the current price to match the total net profit at the previous level of $100. In the article, the OPEC and non-opec producers are using the decrease in price and increase in demand to gain a bigger market share. While this decrease in price is bound to decrease the sales revenue for all oil producers, OPEC producers are trying to recover the lost revenue partially through increased sales. Due to the high cost the non-opec producers incur, they are unable to use the same tactic to increase their revenue. One of the alternatives that was explored by these producers was the reduction of the quantity of oil produced in order to reduce oil supply and cause the price to rise (Lawler, 2015). However, they avoided this strategy after OPEC producers announced their intentions to increase production. This would have eliminated the artificial oil shortage these countries were planning to create and thus would have had no effect on the price. Additionally, they could have a significant part of their market share as well as lose an opportunity of the expanded market due to the increase in demand caused by a decrease in price. OPEC producers decision to increase the quantity produced was meant to increase revenue and prevent loss of market share to Iran whose sanctions are about to be lifted. Iran is one of the single highest producers of oil in the world and oil producers fear that if their

7 SUPPLY AND DEMAND 7 sanctions are lifted price will fall even further due to the increased supply of oil in the market. Additionally, Iran is in the same region as the main OPEC country, Saudi Arabia, and its reentrance into the market will present a threat to Saudi s market (Lawler, 2015). The increased production by OPEC producers has led to there being a surplus of oil in the market. The surplus oil being produced has increased the worries of non-opec producers who have already started losing some of their market share to OPEC producers. By understanding and utilizing the forces of demand and supply, OPEC countries stand to increase their revenue and reduce the impact of reduced prices on their revenue. They have forecasted that demand for oil will continue to increase and the surplus being produced will at some point all be absorbed by the expanded market. In case Iran sanctions are lifted soon, it will find it difficult to recover the market share it lost to OPEC after the sanctions were imposed. Conclusion In sum, the oil market has been negatively affected by the significant decrease of oil in recent months. This effect has been caused by a combination of market factors as well as political factors that play a vital role in the oil market. The conflicts in Ukraine, Middle East, North Africa and Iran s sanctions have all played a key role in the determination of oil price across the world. All these regions are major oil producers and the political conflicts have interfered with their ability to produce as much oil as they used. Another factor that is having an impact on the oil market is the increased use of greener energy. This includes the use of solar energy, electric cars, and wind power among others that are less expensive and more environmental friendly (Rapaport, n.d.). The competition for the market share among OPEC countries and non-opec countries will continue to play a significant role in the determination of

8 SUPPLY AND DEMAND 8 how much is supplied to the market. With time, the increased demand is bound to benefit OPEC countries that have increased their production and still maintained very low production costs.

9 SUPPLY AND DEMAND 9 References Lawler, A. (2015). UPDATE 2-OPEC oil output surge boosts surplus, despite higher demand. Reuters. Retrieved 2 May 2015, from Price, M. (2013). Excessive Supply, Uncertain Demand. Science. doi: /science.caredit.a Puko, T. (2015). Oil Prices Jump on Inventory Data, Demand Outlook. WSJ. Retrieved 2 May 2015, from Rapaport, A. Supply and Demand Shocks in the Oil Market: Theory Applied. SSRN Journal. doi: /ssrn