The Demand and Supply of Oil Commodity During the Period 2000-2005 - Case Study Example

Economics Table of Contents Economics Table of Contents 2 A: Trends in pattern of demand and supply of oil commodity during the period 2000-2005 3 Introduction 3 Objectives and Research Questions 3 Factors determining demand and supply of oil 3 Trends in Demand and Supply of Oil between 2000 and 2005 5 Policy Implications 5 Conclusion 6 B: Why is there an inverse relationship between price and quantity demanded of a commodity? Is this always the case? 7 The Law of Demand 7 Exceptions to the law of demand 8 Conclusion 9 References 9 A: Trends in pattern of demand and supply of oil commodity during the period 2000-2005 Introduction Oil is regarded as one of the most important and highly demanded fossil fuels in the world. Technological advent has propelled the demand for the fuel around the world irrespective of the price of the same. On the other hand, being a natural resource with exhaustible limits, the fuel cannot be exploited boundlessly. The present research attempts to evaluate the trends in the demand and supply volumes of the commodity. Objectives and Research Questions Rationale behind the policy measures undertaken by different economic agents revolves around the profit that they are likely to yield as a result. As oil is regarded as one of the most important raw materials and hence is a decisive factor behind profit generation, it is highly important to keep a track in the price fluctuations of the same. Purpose of this study will be to analyse the gap between demand and supply of oil during 2000-2005 which justifies the price fluctuations of the commodity. In cases of excess demand, prices are likely to soar high in contrast to situations of excess supply. Thus a suitable research question in this case will be to assess the association between policies and availability of oil in the market. Factors determining demand and supply of oil Factors affecting demand of oil Firstly, globalisation has increased the demand of various nations for crude oil which has added to the already high demand for the same. Nations undergoing a period of transition pose a high demand for oil which is regarded as an essential raw material for production. As they are almost always in a rush to improve their economic growth rates, their demand for the fuel is proportionately high. A good example is that of China which has multiplied its demand for oil post the advent of the new millennium, due to similar issues (Energy Information Administration, 2005). Secondly, speculations about political turbulence in the producer nations or chances of stringent ties with their customer nations could lead to hikes in the present demand of oil as the latter want to store more and more reserves of the same. Similar could be the situation when there are possibilities of exchange rate system depreciating in the importing economy. In other words, economies rising high on inflation are likely to demand less of the fuel. Although they might be the consequences of political disruptions, the consuming nations often end up purchasing large stocks of the fuel hence raising its present demand (Pirog, 2005). Lastly, demand for oil is highly dependent upon the availability of other substitute fuels such as coal or natural gas. Regions, which are rich in these resources or could trade them at cheaper prices, attract a lower demand for oil. Moreover, stringency in OPEC policies is also a reason behind the aggregate demand for the fuel. Factors affecting the supply of oil Firstly, the supply function of oil is positively related to the market price of oil in the past. A low market price is of little incentive for the producers who invest lower sums in building refineries and discovering oil mines, to maintain high volumes of future crude oil supplies (Allen, 2005). In addition, higher the market rate of interest is, lower will be the long-run supply of oil in the market as investors will be less attracted towards borrowing and would rather prefer to deposit their money in safe locks (Spann, 1979). Natural catastrophes could prove to be hazardous for the supply of oil as had been the case post Hurricane Katrina. It compelled many on-shore refineries to shut down their supplies both before and after the storm struck thus restricting aggregate supply by a large volume. In addition, it led to a loss of inventories as well thus leading to a serious supply crunch (Bamberger & Kumins, 2005). Trends in Demand and Supply of Oil between 2000 and 2005 The graph alongside depicts the trends adopted by global average demand and supply of oil between 2000 and 2005. It exhibits an upward trend in either of the two cases although world supply of oil had been significantly stunted in 2002. The period between 2001 and 2003 saw aggregate demand beating aggregate supply by a substantial margin as against the phases before and after the span (U.S. Energy Information Administration, 2010). Some reasons which decided the demand and supply of the commodity during this phase are illustrated as follows. Firstly, US came under terrorist attacks during the latter part of 2001 which weakened the economy excessively thus barring its investments in the production of oil for some time. Secondly strikes led by PDVSA Oil Company of Venezuela put to a halt crude oil production in the nation thus adversely affecting the total supply of oil during the initial part of 2003. Iraq, a giant oil producing economy soon after, entered a war with USA due to which the supply of oil around the world dipped down remarkably (Williams, 2009). Policy Implications These disruptions in the supply of oil could lead to fluctuations in the price of the commodity thus largely affecting productive activities around the world. In order to insure against such disruptions, the production houses as well as government bodies could indulge in purchasing oil futures. In addition, the administrative bodies could also indulge in methods to store huge amounts of foreign exchange reserves which could appreciate their respective currencies thus mitigating the impact of high prices. Moreover, the national government might also take initiatives in popularising substitute cheaper fuels which could serve similar purpose as that of oil. Conclusion The present section examined the trends in the demand and supply of oil between 2000 and 2005. Although both factors depict rising trends, there exists excess demand between 2001 and 2003 owing to terrorist attacks in US, strikes entered into by PDVSA workers in Venezuela and war in Iraq. These events led to immense high prices which hampered global production activities. Thus, it is necessary for the administrative bodies to adopt steps such as invention of substitute fuels, stocking up forex reserves and indulging in oil futures, to shield against such hitches. B: Why is there an inverse relationship between price and quantity demanded of a commodity? Is this always the case? The Law of Demand The demand for a commodity is inversely related to the price of the same, as higher the price of a commodity, lower is the utility of consuming the same for the buyer. This low utility is reflected through a reduction in the quantity being demanded. This fact is the foundation of the law of demand that rules an inverse relation between price and quantity demanded not only empirically but mathematically as well. Two of the most pivotal of reasons which establishes this inverse relation are the substitution effect and the income effect. Substitution effect implies the existence of substitute commodities which does not necessitate the consumption of any particular item even after price rises. The flexibility to shift the demand towards a substitute results to a fall in demand of the former item owing to a price rise (Thomas & Maurice, 2008). On the other hand, income effect is that which takes into account the fall in real income of a consumer owing to increased price of a particular item. When the price of a commodity rises, the amount of income left with an individual after consuming the same quantity of the item as before, will fall. Hence, he is no longer in a position to demand equal volumes as before if he wants to keep his disposable income fixed (Anderton, 2000). This is known as income effect where a rise in price leads to a fall in quantity demanded to keep disposable income constant. In the adjoining diagram, as price rises from P3 to P2 to P1, the quantity being demanded is found to fall from Q3 to Q2 to Q1. However, the degree to which an individual is prepared to let go the consumption, decides the person’s elasticity of individual demand schedule. Necessary items often have a highly inelastic demand schedule implying that high prices cannot curb their demand by a huge extent. This is similar to the case for goods which do not have suitable substitutes to replace it. An example is that of common salt which is highly important for cooking but cannot be replaced easily. Hence, common salt has a highly inelastic demand. Similar is the case for items of addiction such as tobacco or alcohol, whose aggregate demands are not affected significantly even after substantial price changes. But, for others such as coffee or tea, the demand curve could be regarded as elastic in nature as either one could be substituted for the other in situations of price rises. The adjoining diagram depicts suitable representatives of elastic and inelastic demand curves. The first one depicts an inelastic demand curve where a fall in price from P1 to P2 results to a rise in quantity by a lower proportion. In the latter graph, on the other hand, a fall in price leads to a hike in quantity being demanded by a greater proportion. Exceptions to the law of demand There might as well be exceptions to the law of demand which might even be found to be upward rising in some special cases. Inferior commodities or Giffen goods, for example, are defined as those whose demands are found to increase with hikes in prices. In line with the substitution effect and income effect being the components of demand schedule, it could be said that Giffen goods are those whose income effect is positive and overrides the negative impact of the substitution effect. When a commodity is inferior, people purchase more and more of the item to throw lesser impact on their real income so that ultimately, higher the price gets, higher goes the demand of the commodity (Anderton, 2000). Examples of Giffen goods are staple food-grains such as maize, millets, etc. which are consumed by the poorer section of the population. Similarly, items of luxury are associated with a positive substitution effect that crosses the income effect of the same. In case of antique items, older that they get, higher goes their price and lower is the substitution effect as a result. Hence ultimately, they end up with an upward rising demand curve. Conclusion The law of demand essentially rules the quantity being demanded as inversely related to the price of the commodity in question owing to negative income and substitution effects. However, there exist some exceptions such as Giffen goods and luxury items, which violate the law and are respectively associated with an upward rising demand curve. References Allen, M. (2005). “Oil Market Developments and Issues” [PDF]. INTERNATIONAL MONETARY FUND. Available at http://www.imf.org/external/np/pp/eng/2005/030105.pdf [Accessed on: May 14, 2011]. Anderton, A. (2000). Economics (3rd ed.). London, UK: Dorling Kindersley. Bamberger, R. L. & Kumins, L. (2005). “Oil and Gas: Supply Issues After Katrina” [PDF]. CRS Report for Congress. Available at http://www.fas.org/sgp/crs/misc/RS22233.pdf [Accessed on: May 14, 2011]. Energy Information Administration. (2005). Petroleum marketing annual. USA: Diane Publishing. Pirog, R. (June 9, 2005). “World Oil Demand and its Effect on Oil Prices” [PDF]. CRS Report for Congress. Available at http://www.fas.org/sgp/crs/misc/RL32530.pdf [Accessed on: May 14, 2011]. Spann, R. M. (1979). The supply of natural resources: the case of oil and natural gas. USA: Arno Press. Thomas, C. R. & Maurice, S. C. Managerial Economics (8th ed.). New Delhi, India: Tata McGraw-Hill. U.S. Energy Information Administrationa. (October 10, 2010). “Total World Production” [Dataset]. Petroleum Statistics. Available at http://www.eia.gov/cfapps/ipdbproject/IEDIndex3.cfm?tid=5&pid=53&aid=1 [Accessed on: May 14, 2011]. U.S. Energy Information Administrationb. (October 10, 2010). “Total World Petroleum Consumption” [Dataset]. Petroleum Statistics. Available at http://www.eia.doe.gov/energyexplained/index.cfm?page=oil_home#tab2 [Accessed on: May 14, 2011]. Williams, J. L. (2009). “Oil Price History and Analysis” [Online]. Available at http://www.wtrg.com/prices.htm [Accessed on: May 14, 2011]. 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