ENM203 Business Essentials Supply and Demand

Supply and Demand

Preview
This topic aims to explain one of the fundamental concepts of economics, the
balance of supply and demand.

Global Energy Supply and Demand

The law of demand states that the higher the price of a product, the lower the
demand will be, all else being equal, see Figure 1.

Demand
Price

A
P1

B
P2

C
P3

Q1 Q2 Q3 Quantity

Figure 1. Source Authors

Points A, B and C on the demand curve represent the relationship between the
quantity of products demanded and corresponding price.
Similarly, the supply curve represents the quantity sold at a certain price. Unlike
the demand curve however, supply shows an upward curve.

Price Supply
C
P1

B
P2

A
P3

Q1 Q2 Q3 Quantity

Figure 2. Source Authors

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In a free market, the price of any commodity will settle at a level where supply is
in equilibrium with demand. This implies that both buyer and seller are happy
with the price and quantity available.
Supply
Price

P1

Equilibrium
Price

Demand

Q1 Q2 Quantity

Figure 3. Source Authors

Where there is excess supply or demand, there is said to be disequilibrium.
Referring to Figure 3, at the price P1 the quantity of products that the producers
wish to supply can be seen at Q2. This indicates the price of the product is too
high and the actual amount consumers wish to purchase is at Q1. Excess supply
has been created.
Supply
Price

Equilibrium
Price

P1

Demand

Q1 Q2 Quantity

Figure 4. Source Authors

In Figure 4 the opposite is true. At P1 the amount of product demanded by

consumers can be seen at Q2, however the amount producers are willing to
supply at this price is Q1. There is little incentive for companies to produce more
at a lower than hoped for price. What will tend to happen is consumers will
compete in order to buy the product at that price. However as competition
increases, price will also increase which will encourage producers to increase
quantity as they will be enticed by the potential for higher profits. Eventually

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price will move closer to its equilibrium.

The supply and demand curves for oil are somewhat different from other
commodities, as shown in Figure 2.

Demand
Price
S1
P1

S2
P2

Quantity

Figure 5. Source Authors

The slope of the demand curve is steep, indicating that even large changes in
price have relatively little effect on consumption. This is because oil cannot readily
be substituted by an alternative source of power. This is an example of price
inelasticity of demand. On the other hand, the slope of the supply curve is quite
shallow, reflecting the fact that traditionally only a small increase in price is
needed stimulate a large increase in production. Historically, this has been due to
the abundance of low production cost oil in OPEC producing countries.
The international oil and gas industry typically reacts to a period of rising prices
by investing heavily in exploration and development in an attempt to take
advantage of improving profitability. This investment has little effect on prices
initially because of the long lead times involved in field development projects, but
when production from new investment starts to come on stream, supplies
increase from S1 to S2 and prices fall from P1 to P2. Typically, the oil industry
now reacts by cutting back on exploration and development expenditure, since
this is no longer so profitable, and supply falls from S2 to S1 as production from
existing fields decline. In response prices begin to rise back towards P1 and the
cycle then repeats itself.
Of course, the above description is very much an over simplification, since it does
not take into account factors such as the behaviour of swing producers in OPEC,
who may seek to restrict or boost production in order to stabilise the oil price
within a range that they believe will maximise their revenue without destabilising
the global economy.

The latest news from OPEC can be accessed through their web site.

http://www.opec.org/opec_web/en/press_room/306.htm

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Macro-Economic Effects
The influence of crude prices on the world’s macro-economic cycle is highly
significant. Higher oil prices created by short supply positions inevitably lead to
inflationary pressures on the global economy. Organisations begin to factor in
higher fuel costs by raising the sale prices of their goods. Individuals respond by
seeking higher salaries to preserve purchasing power. Governments or national
banks try to counter these inflationary pressures by increasing interest rates to
choke back demand, thus squeezing inflation out of the economy. (Higher
interest rates effectively increase the price of goods; anyone with a mortgage can
vouch for this.)
However, if interest rates are raised too aggressively, or too late, business
investment falls, turnover declines, profits are squeezed and many companies are
forced to downsize. This takes further purchasing power out of the economy,
eventually leading to a downward spiral of events ending up in a recession. In
terms of the world market for crude, the effect of any economic downturn can be
dramatic.

Crude Price History

Until recently, the price of crude has in fact remained remarkably stable over
time. Figure 6 shows that between 1880 and 1974, it stayed within the range $10
to $30 per bbl. Traumatic events, such as the two world wars and the great
depression, had only a minor impact on oil price. This may have been due to the
fact that coal was still a dominant energy source and could be used as a
substitute for oil in many applications.

Figure 6. Courtesy of BP Statistical Review of World Energy June 2015

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The oil shock of 1974 was caused by the deliberate decision of OPEC to curtail
supplies. As the major western oil producers could not significantly increase their
production in the short term, this had the effect of moving the supply curve, and
therefore the equilibrium price, dramatically upwards. In fact the price of crude
quadrupled almost overnight.

Since this time the price has been volitile, Figure 7 shows the highs and lows
over the last 10 years.

Figure 7. Courtesy of Macrotrends LLC

The highest real price for crude was achieved in 2008. Depending on which
market is to be believed, the price rose to over $145 per bbl. There were a
number of reasons why this occurred. China’s economy was steadily growing
therefore demand increased. While company’s continued to produce oil they were
not increasing production levels to meet demand and a number of incidents in the
Middle East and Africa disrupted supplies.
Following the ‘boom’ came the ‘bust’. Speculation about the US economy created a
ripple effect, a recession followed and demand dropped dramatically. By December
1998 the price of oil was approximately $16 per bbl, the lowest recorded.

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Oil and Gas Production Trends

Trends in world oil production since 1994

World Oil Production 1994 - Q2 2015

120000

100000

80000

60000

40000

20000

0
1998

2002
1994
1995
1996
1997

1999
2000
2001

2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Figure 8. Figures courtesy of US Energy Information Administration

Oil production has been rising steadily, largely in response to recent increased
demand from a healthy world economy and the continued emergence of China
and India as major energy consumers.
Consumption however has slowed and the industry has experienced the deepest of
downturns in recent times. The price of a barrel of oil fell by more than 70% from June
2014 and speculation suggests it will be years before it returns to $90/$100 which was
considered the norm over the last decade.
The mission of the Organization of the Petroleum Exporting Countries (OPEC) is
“to coordinate and unify the petroleum policies of its Member Countries and
ensure the stabilization of oil markets in order to secure an efficient, economic
and regular supply of petroleum to consumers, a steady income to producers and
a fair return on capital for those investing in the petroleum industry”.

It was reported in 2008 Saudi Arabia did not comply with the vote to reduce
OPEC output which resulted in the dramatic slump in price (as can be seen from
Figure 7). Following a period of global oversupply in the market, 2016 saw an
agreement of the OPEC members to cut production in an attempt to stimulate
price. The agreement which initially covered Q1 and Q2 of 2017 has been
extended until the end of 2018 in an attempt to clear the glut of crude oil.
Whether the agreement will impact significantly on price is yet to be seen.

Further information specific to OPEC and their involvement in the oil market visit:
http://www.opec.org

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Market Forces
In brief

Free Markets and Monopolies

Under conditions of perfect competition, the production and exchange of goods
and services proceeds without interference from government, trade associations
or from the influence of monopolies. In theory prices settle where all supply is
adsorbed by consumer demand.
Most industries are highly competitive, with many discrete businesses meeting
the demands of the market. However, if an industry that produces goods with no
close substitute is acquired by a single entity, a monopoly is created. The price of
goods is then set by the single producer at a higher level than a free market
would dictate. The monopolist uses his market power to set the price of its
output. So-called natural monopolies tend to be created where there is a high
ratio of fixed costs to variable costs. In other words, where a very high up-front
investment is required but once the business is up and running, the marginal
costs of producing a unit of output is very low.
From time to time, governments seek to regulate markets. For example, anti-
trust legislation may be used to break up or regulate monopolies. In 1911, the US
Supreme Court ruled that Standard Oil be broken up into relatively smaller and
competing units to break its strangle hold on the domestic oil market. Until quite
recently, retail price maintenance (RPM) operated in the UK, The government set
a minimum price at which certain goods could be sold so as to discourage the
formation of monopolies. During WW2, when the supply of essential goods was
seriously disrupted, the government sought to regulate demand by rationing. On
the whole this was effective but an active black market was created, in which
rationed goods could be obtained ‘under the counter’ at greatly inflated prices.

Pricing Strategies
For individual businesses, setting a price for its output is a delicate balance
between the demands of the market, the costs of production and a company’s
goals and objectives.
A primary business objective is to maximise profit on the sale of goods and
services. This is achieved when the number of units sold multiplied by the selling
price is maximised. If price is set too high, customers buy less. Competitors may
also be encouraged to enter the market at a lower price to gain market share. If
the price is too low, revenues may not cover the costs of production and sales.
The marginal cost of production is often used by nationalised industries as a
benchmark for pricing strategy. The marginal cost of production is the cost of
producing one extra or one fewer unit. It is argued that this strategy maximises
the benefit to the community as a whole.

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Further Reading & References

BRITISH PTROLEUM, 2015. BP Statistical Review of World Energy June 2015. London.
British Petroleum.

KRAUSS, C., 2016. Oil Prices: What’s Behind the Drop? Simple Economics [online].
New York. The New York Times. Available from:
http://www.nytimes.com/interactive/2016/business/energy-environment/oil-
prices.html?_r=1
[Accessed 24 Feb 2016].

MACROTRENDS, 2016. Crude Oil Price History Chart [online]. Macrotrends LLC.
Available from: http://www.macrotrends.net/1369/crude-oil-price-history-chart
[Accessed 24 Feb 2016]

Sampson, Anthony. The Severn Sisters: The Great Oil Companies and the
World They Created, Coronet, 1988

Schneider, Stephen A. The Oil Price Revolution. Baltimore: John Hopkins

University Press, 1983.

US ADMINISTRATION INFORMATION ADMINISTRATION, 2016. International Energy

Statistics [online]. Washington. US Department of Energy. Available from
https://www.eia.gov/cfapps/ipdbproject/IEDIndex3.cfm?tid=5&pid=53&aid=1
[Accessed 24 Feb 2016].

Yergin, Daniel, The Prize, Simon and Schuster UK Ltd, 1991. An excellent account of the
history of the oil industry and its impact on world economics during the 20th Century.)

In addition there is a wealth of information to be found on the Organization of the

Petroleum Exporting Countries (OPEC) webpages. The Monthly Oil Market Report
provides up to date information on issues affecting the world oil market. The World Oil
Outlook presents future challenges and opportunities which may lie ahead within the
industry.

www.opec.org

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