Adjusting to Oil Price Shocks

Short-run and long-run demand and supply curves

Between December 1973 and June 1974, the Organization of Petroleum Exporting Countries (OPEC) put up the price of oil from $3 to $12 per barrel. It was further raised to over $30 in 1979. In the late 1980s the price fluctuated, but the trend was downward. Except for a sharp rise at the time of the Gulf War in 1990, the trend continued in the early 1990s. By 1996, the price was fluctuating around $16 per barrel: in real terms (i.e. after correcting for inflation), roughly the level prior to 1973. The situation for OPEC deteriorated further in the late 1990s, following the recession in the Far East. Oil demand fell by some 2 million barrels per day. By early 1999, the price had fallen to around $10 per barrel a mere $2.70 in 1973 prices! In response, OPEC members agreed to cut production by 4.3 million barrels per day. The objective was to push the price back up to around $18$20 per barrel. But, with the Asian economy recovering and the world generally experiencing more rapid economic growth, the price rose rapidly, reaching over $35 in late 2000. The effect was to trigger protests around the world, with pressure on governments to cut fuel taxes. Pressure on the oil price eased over the next couple of years and in 2001 the price fell back to $24 per barrel. However, the war in Iraq, rapid growth in demand from China and concerns about world oil production pushed it strongly upwards from 2003 onwards, with the price reaching $80 per barrel in August 2006. The price movements can be explained using simple demand and supply analysis.

The initial rise in price

P

S2 S1
P2 B

P1

D1 (short-run)
O Q2 Q1 Q

Diagram (a) An initial restriction of supply

Diagram (a) shows the effects of OPECs actions: the price rises from P1 to P2. To prevent a surplus at that price, OPEC members restricted their output by agreed amounts. This had the affect of shifting the supply curve to S2, with Q2 being produced. This reduction in output needed to be only relatively small because the short-run demand for oil was highly priceinelastic: for most uses there are no substitutes in the short run.

Long-run effects on demand

The long-run demand for oil was more elastic. This is shown in Diagram (b). With high oil prices persisting, people tried to find ways of cutting back on consumption. People bought smaller cars. They converted to gas or solid fuel central heating. Firms switched to other fuels. Less use was made of oil-fired power stations for electricity generation. Energy saving schemes became widespread both in firms and in the home.

S2
B

S1

P2

P3

C A

DL D2
O

D1
Q

Diagram (b)Long-run demand response

This had the effect of shifting the short-run demand curve from D 1 to D2. Price fell back from P2 to P3. This gave a long-run demand curve of DL: the curve that joins points A and C. The fall in demand was made bigger by a world recession in the early 1980s.

Long-run effects on supply

With oil production so much more profitable, there was an incentive for non OPEC oil producers to produce oil. Prospecting went on all over the world and large oil fields were discovered and opened up in the North Sea, Alaska, Mexico, China and elsewhere. In addition, OPEC members were tempted to break their "quotas" (their allotted output) and sell more oil. The net effect was an increase in world oil supplies. In terms of the diagrams, the supply curve of oil started to shift to the right from the mid-1980s onwards, causing oil prices to fall through most of the period up to 1998. This is shown by a shift in the supply curve to S 3 in Diagram (c). Equilibrium price thus fell back to P1 (point D). Note that the supply curves in these diagrams are all short-run supply curves, since each one shows supply for a particular number of oil fields.

S2
B

S3 S 1

P2

P3

C A

P1

D2
O

D1
Q

Diagram (c)Long-run supply response Drawing a long-run supply curve is more difficult: it depends when in the story we start and what assumptions we make. We could draw a long-run supply curve linking points E and F in Diagram (d).
P

S2
B

S3 S 1

SL

P2

P3 E

F A

P1

D2
O

D1
Q

Diagram (d) Constructing a long-run supply curve

The reasoning is as follows. After the limiting of supply to S2, OPEC members would have supplied at point E, had the price remained at P 1. After some years with the price set at P2 or thereabouts, more suppliers enter the market. The supply curve shifts to S 3. Had the demand curve not shifted, equilibrium would then have moved to point F: the intersection of S3 and the original demand. A long-run supply curve thus links points E and F.

Back to square one and worse

By the late 1990s, with the oil price as low as $10 per barrel, OPEC once more cut back supply. The story had come full circle. This cut-back is illustrated in diagram (a). The trouble this time was that worldwide economic growth was picking up. Demand was shifting to the right. The result was a rise in oil prices to around $33, which then fell back again in 2001 as the world slipped into recession and the demand curve shifted to the left. There were then some large prices increases, first as a result of OPEC in late 2001 attempting once more to restrict supply (a leftward shift in supply), and then, before the Iraq war of 2003, because of worries about possible adverse effects on oil supplies (a rightward shift in demand as countries stocked up on oil). In 2004 OPEC relaxed its quotas to try to prevent the price rising further, but problems with supply limited how much it could shift the supply curve to the right to ease the price. Worries about insecurity of supply, combined with the rapid economic growth of China, continued to shift the demand curve to the right and, as stated at the beginning of this case study, by August 2006, oil prices had risen to around $80 per barrel.

Question Give some examples of things that could make the demand for oil more elastic. What specific policies could the government take to make demand more elastic?