Fundamental Economic Theories Application to the Calculation of Oil Prices

World fuel prices are believed to be defined by the relation between supply and demand of fuel in the world market in a particular moment of time, and accordingly by the factors, which form such supply and such demand. Nevertheless, the spikes in oil prices can be seen contradicting the supply and demand of oil, which in turn might put a question whether the fundamentals of economic theories are applicable to oil prices. In that regard, this paper discusses the oil prices bubble, stating that indeed the rises in oil prices are subject to fundamentals economic theories, particularly the supply and demand theory.

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The first point of the application of supply and demand theory can be seen through the explanation of the factors of the price of oil spikes. The first one can be seen through the Yom Kippur war, where the rise continued from 1973 to almost 1980, with an increase from $3 to 40$ (Smithson, 2007). According to the supply and demand theory, the demand is inversely correlated with the price, while the supply is directly correlated with the price. Additionally, the oil as a product that has high inelasticity, the supply, and the demand react on a smaller scale to the changes in prices, and the opposite can be true, where small changes in demand and supply result in higher increases in the prices; usually implies elastic products (Smithson, 2007).

Accordingly, it can be assumed that the Yom Kippur War, and the formation of OPEC, as well as the decrease of supply, had an ulterior motive of raising the prices, as a punishment of the countries participating in the war. The point is that the shift in supply was artificial, but nevertheless, it was applicable to supply and demand theory, and thus, such shifts in supply and demand, given that the elasticities of supply and demand are estimated “allows one to approximately identify actual shifts in supply and demand curves based on observed prices and quantities” (Smith, 2009). Additionally, the justification of such a price spike, specifically, after the Yom Kippur war can be seen through the spike being partly an objective, rather than an uncontrollable side effect.

Another example of non-artificial spike applicable to the supply and demand theory can be seen through the reduction of the production in the Gulf of Mexico, due to the Katrina Hurricane, which had a similar result, i.e. reduced supply, increased price, and accordingly a shift of the supply curve to the left. The amount of the increase can be largely attributed to the amount of supply reduced, the decrease taking place outside of the OPEC (Blanchard and Galí, 2008), and assumingly by “contagious excitement about investment prospects” (Yergin, 2008), a term although introduced recently by Professor Robert Shiller of Yale, and was applicable to the housing and the mortgage market, can be seen appropriate to the situation back then. The latter can be explained through the fact that although the increase in price might have been initiated by a correlation in the supply, its further increase, which might have far exceeded the range of the supply reduced, was driven by contagious excitement. It should also be mentioned that the rise in the prices “has coincided in time with large shocks of a very different nature (e.g. large rises in other commodity prices in the 1970s, high productivity growth, and world demand in the 2000s) (Smith, 2009), which increased the spikes in prices, and made it difficult to assess the rises in prices and relate them to the fundamentals.

Now taking the example, of the most recent rise, i.e. 2004-2008, it can be seen that it was also associated with the supply. This time the decrease in the supply came from the non-OPEC countries which coincided with an increase in demand, which accordingly can be explained in that a shift of the supply curve to the left and a shift in the demand curve in the right simultaneously, increase the prices in a steep manner (see Figure 1).

Supply and Demand Shifts
Figure 1: Supply and Demand Shifts

Through the periods other than such and other spikes it can be seen that trend of price increase is regulated through the gradual rise in demand, which is followed by an increase in the supply. The trend can be extracted from the price fluctuation in the period from 1970 to 2008 (see Figure 2).

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The rise of the prices
Figure2: The rise of the prices (Blanchard and Galí, 2008)

Accordingly, it should be mentioned that an increase in supply, when the demand decreases, it’s hard to be reduced, as long as the expansion in production already took place. In that regard, it should be mentioned that increases in prices are mostly justified by the theory of supply and demand, and despite the fact that price spikes can be artificial, they are nevertheless, justified through fluctuations in supply and demand, which to an extent can be amplified by other factors.

References

BLANCHARD, O. J. & GALÍ, J. 2008. The Macroeconomic Effects of Oil Price Shocks: Why are the 2000s so different from the 1970s? CEPR Discussion Paper No. DP6631.

SMITH, J. L. 2009. World Oil: Market or Mayhem? Journal of Economic Perspectives, 35, 145–164.

SMITHSON, R. 2007. The Economics of Oil, Part I: Supply and Demand CurvesWeb.

YERGIN, D. 2008. What lower oil prices mean for the world. Web.

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