Supply and Demand, Elasticity, and Oil Prices

¶ … 22nd of April 2014 in the Wall Street Journal, it is reported that the prices for oil futures are showing a significant decline (Friedman, 2014). Contracts are quoted as falling by 2.2% for the May settlement contracts and 1.8% for the June settlement contracts (Friedman, 2014). It is noted that the prices for the oil futures contracts have fallen ahead of the release of .S. Energy Information Administration regarding the level of domestic oil reserves. The falls are believed to reflect the expected announcement that the reserves are at a significant increase in the level of the oil reserves (Friedman, 2014). In a survey 8 out of 10 analysts surveyed indicating they expected the level of reserves to rise (Friedman, 2014). It is stated that on April 11th the oil reserves were only 3.4 million barrels below the peak which was seen in May 2013, and that it was expected the level was to increase by 2.8 million barrels taking it even closer to the all time high (Freidman, 2014). The increasing level of supply is being facilitated by improved technology allowing more oil reserves to be tapped.

The article has also noted that there has been an increase in the Brent Crude spot oil prices, following fears that the unrest in the Ukraine may escalate, and disrupt oil supplies (Freidman, 2014). It is also stated that it is expected the increased pressure in the spot prices is expected to dissipate as the events show that the Ukraine position will have little impact on Russia's ability to produce oil. The movements in the oil prices can be considered in the context of the economic concepts of supply and demand, and elasticity.

The influence of supply and demand as well as elasticity can be seen in the way oil prices are moving, both price in the oil futures and the spot prices. Supply and demand will be considered first, looking at both the futures and the spot prices.

Price for a commodity will be influenced by a number of factors, the most important being the balance which is achieved between supply and demand. In any market, where all other factors remain the same, if the supply of a product exceeds the demand, resulting in a surplus, the price of that product is likely to fall (Baye, 2007). The price will fall in order to try and attract more purchases to the marketplace, with most products becoming more attractive to purchases as the price decreases. As the price falls and the related profit associated with that product falls, (assuming that all other factors remain the same), there is also the potential that some suppliers may also withdraw from the market, reducing the supply (Baye, 2007). Where the supply exceeds demand price will continue falling until a new pricing point is reached where supply and demand meet (Baye, 2007).

Examining the situation regarding futures for oil reported by Friedman (2014), it is argued that the prices of futures are falling as there is expected to be an increase in supply. The article is written ahead of the results of the official figures, but the article quotes a survey in which 8 out of 10 analysts indicated they believed that the all reserves were going to increase significantly (Friedman, 2014). In line with the general supply and demand relationship discussed above, where supply increases, which would be the case if there is increasingly reserves, and there is no proportional increase in demand, the potential level of service would increase, and therefore the price will decrease. However, in this case the concept of elasticity is also important.

Elasticity refers to the degree to which demand will change based on the changes in prices. Elasticity is calculated using historical figures regarding previous price changes. The calculation is a division, where the percentage change in the quantity of the good demanded is divided by the percentage change in the price. For example, if the demand decreases by 25%, then there is an increase in price of 25% the calculation will be -25/25 which is the result of -1. It is usual to drop the minus from the result. A score of one means that for every 1% change in price there will be a corresponding 1% change in demand. This is perfect elasticity. Where the score is over 1 a product is seen to be very elastic, which means that any changes in price will result in a disproportionately larger increase or decrease in demand (Baye, 2007). If the result is less than one, the product is classified as being inelastic, which means that any changes in price will not result in equivalent changes in demand. Inelastic products tend to be essential goods which are needed, regardless of their price, for example power utilities, as well as goods associated with addiction, such as tobacco (Baye, 2007). Oil is classified as an inelastic product, as it is an essential product for many industries, and the demand remains the same even if the price increases, likewise, the demand will also remain similar even if the price decreases (Kilian, 2009). The article, which shows a decreasing the price of oil futures as a result of an increasing level of supply, is unlikely to impact significantly on the overall short-term demand for oil. However, where there is a product that is inelastic, and it is expected that prices are likely to increase significantly over a period of time, while the short-term demand may not be impacted, alternate long-term solutions may be found to replace the commodity that is seeing an increase in long-term price; research investment may result in changes elasticity through the creation of substitutes. In effect, the upward pressure on prices may stimulate the creation of substitutes may increase alternatives and the overall level of competition.