Economic Principles - The Price of Oil in the Long Run

Assignment B
The Price of Oil in the Long Run

“For an industry or economic problem of your own choice, use the various economic
concepts introduced and developed in this course to explain a current economic
phenomena of interest.”

Prepared for Module CB9001

“Economic Principles”
by
Carlos Ferreira

Submitted on the 28th November, 2008

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 Economic Principles - The Price of Oil in the Long Run

Oil is the single most important commodity in the world today, and the world's most
important source of energy for years in the future (EIA, 2008). Its price in the market is
explained by supply-and-demand factors, but taking account of the non-renewable nature of oil.
Our analysis will concentrate in the long run, therefore abandoning constraints in the
inputs used for oil production.

1. The demand for oil

The International Energy Agency (EIA) and the Organization for the Economic
Cooperation and Development predict that, under current conditions, world demand for oil will
grow at an average of 1% per year in the period between 2006 and 2030 (EIA, 2008). This
demand is highly inelastic: estimates of the long-run price elasticity of demand for oil in different
countries (Cooper, 2003) show values between -0.568 and -0.033. These very low price
elasticities of demand point out to very steep demand curves:

P
D1 D2

Q
Chart 1: hypothetical demand curves for 2006 (D1) and 2030 (D2)

Chart 1 depicts this situation: it represents a hypothetical set of demand curves for 2006
(D1) and 2030 (D2), all other variables being constant.
This gives us no indication of the price of oil. Arguably, the prospect for the long term
price of oil is dominated by the supply side.

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 Economic Principles - The Price of Oil in the Long Run

2. The oil supply

Oil fields' production over time follows a roughly bell-shaped curve, with a rising
output up to the peak, then followed by a decline (Horsnell at al., 2008), as represented in Chart
2:

Oil Marginal Cost

Production Rate of Cost
Production

Average
Cost

Time
Chart 2: oil production in one field over time, and the respective Marginal Cost and Average Cost

After this peak is reached, more energy is required to extract oil from the deposits; since
the Marginal Cost of oil is a function of the energy needed to extract that same oil (Hanley,
Shogren & White, 2007), we can predict that the marginal cost of extracting oil from a well will
increase in time, up to the point where it equals the market price, at which point the well is
closed, only to be re-opened as the price of oil increases enough to make the extraction from it
profitable again (Adelman, 1990). Consequently, while consumers access standard products
refined from oil, producers are faced with different characteristics of the different fields where oil
is extracted and different characteristics of the oil extracted itself. This means that the Marginal
Cost of an oil barrel will be different among producers and among different oil fields belonging to
the same producer.
As the various existing oil fields reach their production peak and their output decreases,
new fields must come online to make up for the world's growing demand. Due to the non-
renewable nature of oil, new oil fields take investment to find, to set up all the extraction
hardware needed and to maintain and increase production in the face of geological constraints,
and to develop new means of increasing the total part of the oil in the reservoir that's

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 Economic Principles - The Price of Oil in the Long Run

economically extractable. The EIA states that further investment in discovery and development
in new fields will be the key to maintaining the necessary supply in the period between 2006
and 2030 (EIA, 2008).
These second type of costs (development-investment) are sunk costs. However, they do
impact the cost of oil in an indirect way: if the price of can be determined by the formula (Hanley,
Shogren & White, 2007):
p = MC + μ
where p is the price, MC is the Marginal Cost of extraction and μ is a measure of uncertainty (a
function of the proven reserves that can be economically recovered from the reservoir),
development-investment raises the reserves, in the process lowering the uncertainty and,
consequently, the price of oil. Therefore, the price of oil is not a function of the total amount of oil
available in the world, but instead of the proven extractable reserves.
This development-investment is an opportunity cost: as long as the potential profit from it
is greater than the discount rate available for investors, there will be further investment – this
conforms to the “Hotelling's Rule” (Cairns, 2000; Gaitan S. et al., 2004). If the price of oil were to
remain constant as the natural occurring oil diminished, the return on investment would be
reduced, because the same investment would yield an ever smaller increase in recoverable
reserves, and the opportunity cost of investment would increase; when return on investment
equals the discount rate (T1 in Chart 3), and investment in the industry will stop (Adelman,
1990):

Value Quantity
Quantity
($)
in Nature

Discount
Rate

Return
on
Investment

T1
Time
Chart 3: Return on investment, quantity of oil and discount rates over time, with a constant price of oil

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 Economic Principles - The Price of Oil in the Long Run

The conclusion is that, for development-investment to remain at the levels need to

sustain increases on production, it's necessary to maintain the return on that investment. Since
ever less reserves are found for the same amount of investment (Horsnell et al., 2008), the
price of oil must increase to maintain the return on investment.

3. Conclusion
Chart 4 depicts the predictable trajectory of the price of oil, accounting for the increase in
demand oil and the foreseeable difficulty in increasing the supply. In time, demand shifts from D 1
to D2, supply responds by shifting from S1 to S2, therefore increasing the total available quantity
of oil available from Q1 to Q2, but also increasing the price from P1 to P2.

S2
P
D1 D2

P2

S1

P1

Q1 Q2 Q
Chart 4: Hypothetical supply and demand curves for oil

We have demonstrated that the price of oil in the long run will increase, because of
growing demand and rising cost of supply. We believe that this assumption would hold even if
the market for oil was perfectly competitive, instead of dominated by a cartel of producers
(Hanley, Shogren & White, 2007; Horsnell et al., 2008), due to the non-renewable nature of oil.

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 Economic Principles - The Price of Oil in the Long Run

References

Adelman, M. A. (1990). Mineral Depletion, with Special Reference to Petroleum. The Review of
Economics and Statistics. 72 (1) February, pp. 1-10.
Cairns, R. D. (2000). Accounting for Resource Depletion: A Microeconomic Approach. Review of
Income and Wealth. 46 (1) March, pp. 21-31.
Cooper, J. C. (2003). Price Elasticity of Demand for Crude Oil: Estimantes of 23 Countries.
OPEC Review. 27 (1) March, pp. 1-8.
Gaitan S., B., Tol, R. S. J. & Yetkiner, I. H. (2004). The Optimal Depletion of an Exhaustible
Resource in a Dynamic General Equilibrium Model. American Agricultural Economics
Association Annual Meeting. Denver, Colorado.
Hanley, N., Shogren, J. F. & White, B. (2007). Environmental Economics in Theory and Practice.
2nd ed. Hampshire, Palgrave Macmillan.
Horsnell, P., Jacazio, C., Norrish, K., Sen, A., Snowdon, N & Yu, Y. (2008). Barclays Capital
Commodities Research, November 2008 [Internet]. Research Report. London, Barclays Capital.
Available from <https://ecommerce.barcap.com/research/user/article/attachment/.../0/Oil
%20Sketches%20Monthly%205%20Nov%2008.pdf> [Accessed 09/Nov/2008].
International Energy Agency (2008). World Energy Outlook 2008 – Executive Summary
[Internet]. Paris, International Energy Agency. Available from
<http://www.iea.org/Textbase/npsum/WEO2008SUM.pdf> [Accessed 09/November/2008].

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 Economic Principles - The Price of Oil in the Long Run

EXPANSION IDEAS!

- elasticity of demand may be different (long run, no constraints; people invest in capital equipment, like cars, than
run on different sources of energy);
- The part of the price of oil that effectively impacts on fuel prices, and how it increases with the increase in cost of
crude oil (48% average in the period from 2000 to 2007; 58% average in 2007) and how this could help the
mentioned price elasticity of demand increase, by increasing the input elasticity of demand - oil is a product for the
oil industry and an input for everyone else;
- The investment in alternatives effectively creates a substitution effect; I was going to create a new version on the
price equation, accounting for this impact - investment in alternatives over time diminishes the shadow price of oil
and diminishes the demand; so it could, after some point, contribute to diminishing the price of oil
- The impact of cartel behaviour - OPEC will rule the market as production from non-OPEC decreases and demand
increase, ceteris paribus