OPEC’s strategy and the quadrupling of oil prices
Over the past several decades, the world market for oil are faced with most disruptive events. The members of Organization of Petroleum exporting countries raised the price of oil for increasing their income. This was done by reducing the amount of oil supplied on jointly basis. Oil price rose for more than 50% after adjusting the inflation rate from 1973 to 1974. Oil price was approximately doubled from 1979 to 1981 resulting from same strategy. However, maintaining the price of oil at higher level was difficult, there was a steady decline in oil price from 1982 to 1985, and the fall was about 10% per year. The episode of oil price trends in 1970 and 1980 depicts how demand and supply can have different behavior in long run and short run (Arezki et al., 2017). Factors underlying the expectation of demand and supply are complex.
Demand and supply in world oil market are balanced through the responses to movement in price. Demand and supply of oil are relatively inelastic in short run. Supply of oil is considered as inelastic because there cannot be instant change in the capacity of oil extraction and oil reserves quantity. Demand is relatively inelastic there cannot be immediate change in buying habits resulting from change in price (Sonmez, 2016). Therefore, in short run demand and supply curves are relatively steeper. Considering the situation of long run that is very different from short run. High oil prices in the long run receive different response in terms of quantity extracting and supplying oil (Baffes et al., 2015). Oil producers outside OPEC would respond to higher oil prices by building new extraction capacity and oil exploration. This would cause the supply and demand curve to shift and the shift will be flatter.
Considering the analysis discussed above, it can be shown that OPEC succeeded in maintaining higher price of oil only in the short run. This was so because price of oil was not immediately adjusted for reduced supply. Reduction in oil supply in short run increases price of oil by significant value and this ultimately rose the income of OPEC members. In the economic jargon, the concept of elasticity of supply and demand relating to oil are referred. Responsiveness of production and consumption of oil to change in their price are measured through elasticity. Estimates of supply and demand price elasticity of oil vary widely and there is a significantly rise in elasticity due to adjustments made in production decisions and spending habits (Ghassan & AlHajhoj, 2016).
Oil prices from 1970 to 1992
The oil price impacts relating to elasticity of demand and supply is assessed and OECD areas comprised of one of the main region of world oil demand.
Trend of oil price from 1970 to 1992:
(Source: created by author)
In 1970s, OPEC decided to cartel its power and this has resulted in quadrupling oil price. There was significant lag that took place in such processes to take effect due to short-term elasticity of demand of oil. Despite wide swings since year 1975, trend toward lower oil intensity of the global economy was inexorable. Furthermore, slow demand growth was experienced resulting from falling oil intensity and long-term growth. Since 2000, the process of decreasing intensity of oil accelerated increase in price of oil. Price of oil are expected to trend upward and do well above rate of inflation, despite two price shocks in 1979-1980 and 1973-1975 (Kisswani 2014).
Inelastic demand of oil in short-run similar to that existed in US in 1973
(Source: created by author)
Short and long-run analysis of demand and supply of oil
Elastic demand over long term and supply curve shifting:
(Source: created by author)
The demand and supply of oil can be explained with the help of concept of elasticity as depicted in above graph. In graph 1, before the OPEC shock, price was roughly doubled. Initial equilibrium took place at (17, 12). Reduction in supply shifted the curve to left side causing an increase in equilibrium price to $ 25 per barrel. Since, supply is increasing by considerable amount, in order to arrive at equilibrium, demands needs to be decreased for which there is significant increase in price. On the other hand, it can be seen in second graph that in long run, demand for oil is more elastic. There is less increase in price of oil in order to arrive at alternative equilibrium. Price of oil is increasing to $ 14 per barrel with equilibrium quantity being reduced largely. Demand curve in different in both the graphs. In first graph, new equilibrium price has resulted in smaller decrease in quantity demanded with higher price. Second graph has resulted small increase in price and reducing quantity by larger amount. Main reason for lower quantity demanded is attributable to higher prices of energy resulting from conservation efforts making energy demand curve relatively more elastic (Sonmez, 2016).
It is predicted by economic theory over the long period that demand and supply of oil should be highly responsive to price. High price of oil in 1970 was consistent with economic theory and this was followed by a surge in production and non-OPEC investment. For over ten years, following the price shock in 1979-1980, demand for oil stagnated over the years (Mohaddes & Pesaran, 2017). There was essentially no growth in demand of oil after the expansion of global economy. As depicted by data, when the supply of oil rose in response to higher rise in price of oil, there was significant slowdown in rate of growth of demand in oil (Bornstei et al., 2017). The results higher value for long-run elasticity of supply and demand as predicted by economic theory.
Conclusion:
For the outlook of the market of oil, one of the vital implication is to understand the concept of elasticity. It is projected that future global demand will be considerably lower, if the price of oil will rise at faster rate. The concept of elasticity is more important if the price of oil is higher. Therefore, in response to higher price of oil, supply will expand at faster rate and on other hand; demand will expand at slower rate.
Reference:
Arezki, R., Laxton, D., Matsumoto, A., & Nurbekyan, A. (2017). Oil prices and the global economy.
Baffes, J., Kose, M. A., Ohnsorge, F., & Stocker, M. (2015). The great plunge in oil prices: Causes, consequences, and policy responses.
Bornstein, G., Krusell, P., & Rebelo, S. (2017). Lags, Costs, and Shocks: An Equilibrium Model of the Oil Industry (No. w23423). National Bureau of Economic Research.
Ghassan, H. B., & AlHajhoj, H. R. (2016). Long run dynamic volatilities between OPEC and non-OPEC crude oil prices. Applied Energy, 169, 384-394.
Kisswani, K. (2014). OPEC and political considerations when deciding on oil extraction. Journal of Economics and Finance, 1-23.
Mohaddes, K., & Pesaran, M. H. (2017). Oil prices and the global economy: is it different this time around?. Energy Economics.
Serletis, A., & Asadi Mehmandosti, E. (2016). 150 Years of the Oil Price-Macroeconomy Relationship.
Sonmez, S. (2016). The Macroeconomic Response to Oil Price Shocks from 1970-2013 (Doctoral dissertation, The New School).
Order an Essay Now & Get These Features For Free:
Turnitin Report
Formatting
Title Page
Citation
Outline
