CLA 2 Paper & PPT - Managerial Economics

Running head: OIL MARKET 2 1

OIL MARKET 2 8

Oil Market 2

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Introduction

Oil as a product is essential to the global economy (Inkpen & Moffett, 2011). Efforts have been made to reduce its usage in many countries, citing its negative impact on the environment (Carson, 2015). However, the product has very high demand globally since it is used in many ways, e.g., automotive gasoline, lighting lamps, and generator air crafts. Crude oil production in USA has been declining from 2000 to 2010; however, the production went up from 2011 to 2020 where the production declined again. In 2020 the country produced 12.8 barrels daily in January, but by March 2020the crude oil prices had declined due to low demand following the covid 19 effect globally. Though the demand for oil decline, the production also declined as most of the wells were closed down. For instance, in the US, the production reduced to 10.0 million barrels per day.

The Market Structure for the Oil Industry

The oil market structure can be termed an oligopoly market where few firms dominate the market(Carson et al., 2020). In this market, the firms are interdependent, i.e., any change made by a firm in the industry affects the other firm, thereby causing counter actions by the other firms. For instance, if SNP company lowers its prices, the other companies will also reduce their prices to have an equal market share with their rival company. The characteristics of an oligopoly market are in such a way that there are a few firms in the industry; in this case, the major oil firms globally are SNP, PTR, Saudi Aramco, RDS.A, BP, Exxon Mobil, TOT, CVX, MPC, and LUKOY. As mentioned, these are the ten major oil companies in the world. They are very few considering the market demand for oil globally. These companies originate from major oil-producing countries. In this industry, the firms do not compete, but they conspire to control the oil prices and availability. The other characteristic that makes oil companies an oligopolistic market, is that small firms may find it challenging to join the oil industry because of unfair competition with the large firms. In this case, the large firms create barriers for the small firms' entry.

The interdependence of the oil firms can be well demonstrated in the following tables.

Suppose NSP Company lowers its price, and the other companies do not copy

Price	Quantity	Revenue
10	1barrel	10 M
9	2barrel	18M
8	3 barrel	24

Other Companies

Price	Quantity	Revenue
10	0.5	5M
10	0.25	2.5M
10	0.2	2M

When the other companies lower their prices

Price	Quantity NSP	Revenue NSP	Quantity other companies	Revenue
10	1barrel	10 M	1 barrel	10M
9	2barrel	18M	2barrels	18M
8	3 barrel	24	3barrels	24M

From the above example, if the other firms do not reduce their prices when NSP firm reduces its price, they will lose to NSP company(Cypher & Larson, 2016). On the other hand, if the other companies lower their prices with the same margin as NSP Company, the market share will be equal.

The Supply and Demand in the Market Structure

In normal circumstances, the demand elasticity for the oil is very low compared to the changes in prices (Cypher & Larson, 2016). This is because oil products are essential products that consumers will still buy, no matter the price. The supply elasticity of oil products, on the other hand, is also low. This is because the equipment and machines used to drill oil cannot be used for any other purposes; therefore, they remain at work even when the prices are low. Since a price change in one company may lead to a price change in the other companies, i.e., if one company lowers its prices, the other company will also lower its prices. This will results in a kinked demand curve, as shown.

In the above graph, if the company lowers its prices below six, the demand will move to D2, but if the company raises its price above $6, the demand will move to demand D1(Guell, 2017). The kinked demand curve results in the firm having a gap in the marginal revenue depending on the increase or decrease of prices on the quantity demanded.

The supply curve in an oligopoly market takes the normal supply curve. (Guell, 2017) However, the price changes may not have a significant difference in the quantity supplied. However, if the firm is dominant, the supply and the demand curve may be as follows.

From the above graph, the dominant firm's marginal cost is its supply curve; thus, the firm can reduce its marginal cost due to its economies of scale. The dominant firm will set its demand at the dashed demand curve portion setting the marginal at par with the marginal revenue. In so doing, the firm will have developed the ideal output for profit maximization.

The Pricing of Oil Under OPEC and the Role of Speculators

OPEC is an international cartel aimed at stabilizing the global oil market. Some of its members are Kuwait, Saudi Arabia, Iran, etc. (Guell, 2017). The cartel regulates the oil prices and the supply of oil by its member countries in the market. The firms come together and agree on a price and manipulate the global supply and oil prices. However, the OPEC countries are not the major oil-producing countries; thus, the cartel has not dominated the market to set prices. The OPEC countries compete with the non-OPEC countries whose oil production is higher than the OPEC member, e.g., USA, Norway, etc. The member countries OPEC has set quarters in which every member should supply and sell under the cartel. This reduces competition among members.

The speculators are investors who anticipate futures on trends to make profits(Guell, 2017). Their role is to predict the future prices of oil. Once they establish that the price will rise in the future, they buy more oil products to sell them when the prices shoot.

Why is Shale Oil a Substitute for Oil?

Shale oil is extracted from the shale formation (Speight, 2012). It is a form of oil that can be used for lighting, automotive fuel, etc. shale oil is used in the same manner as oil which is why it is taken as a substitute for oil. The difference between shale oil and tight oil is that shale oil is extracted from sedimentary rocks and has permeability, while tight oil is extracted from rocks formations.

The Cross Elasticity Of Demand

Cross elasticity of demand compares the effect of changes in the price of two related commodities (Speight, 2012). The normal rule is that when the price of a substitute product increases, the demand for that product reduces. This is because people will buy the product whose price is low, thus increasing its demand.

Conclusion

The prices for oil products are dictated by the demand and supply of the products. However, the price change may not significantly affect the demand for oil production since the demand price elasticity is very low(Speight, 2012). Supply for the oil is also not so much affected by the changes in. price. Oil products are in very high demand and explain why the price changes do not affect the demand and supply of the product.

References

Carson, R. B. (2015). Economic issues today: Alternative approaches. https://doi.org/10.4324/9781315705002

Carson, R. B., Thomas, W. L., & Hecht, J. (2020). Economic regulation. Microeconomic Issues Today, 112-134. https://doi.org/10.4324/9781003059547-8

Cypher, J. M., & Larson, R. (2016). Current economic issues, 20th ed.

Guell, R. (2017). Issues in economics today. McGraw-Hill Education.

Guell, R. (2020). Loose leaf for issues in economics today. McGraw-Hill Education.

Speight, J. G. (2012). Shale oil production processes. Gulf Professional Publishing.