What better way to test price elasticity with that most insanely difficult commodities to price, oil. Most people say that oil price is determined by the whims of local dictators rather than by the laws of supply and demand. But lets have a slightly closer look, and see how it goes. Maybe we can get some trends.

First lets look at the price of oil. For our analysis, which is hardly going to be in depth, we will only bother about the last 2 decades or so.

Year

Prices

Consumption

(million barrels/day)

1988

18.53

65

1989

14.91

66

1990

18.23

67

1991

23.76

67

1992

20.04

66

1993

19.32

65

1994

17.01

67

1995

15.86

69

1996

17.02

71

1997

20.64

72

1998

19.11

74

1999

12.76

75

2000

17.9

77

2001

28.66

78

2002

24.46

79

2003

24.99

81

2004

28.85

83

2005

38.26

85

2006

54.57

86

2007

65.16

87

The data above is a little detailed, but anyone will notice that as the price goes up, the consumption of oil is increasing. This is rather silly, is it not? After all, the price elasticity thing says that if the price of a commodity goes up, the demand for it will go down. Yet, oil consumption has gone up rather than down. Not at all as per theory, is it?

Well, there is a reason for that. While the overall consumption of oil has gone up, a breakup of regions tells an interesting story. While global demand has gone up by about 22 million barrels a day, North America has only risen by 4 million barrels, and Western Europe is even worse, with practically no change in consumption. It is in Asia where consumption has shot up, with Asia accounting for an increase of almost 13 million barrels a day, which is an incredible 60% of the global increase in consumption. Africa and the middle east account for the remaining rise.

Now, the reason why prices have gone up and consumption is still moving up is becoming a bit clearer. The problem is that a previous zero consumer has entered the market, and the production of oil must catch up. Until then, the prices will just keep going up. In the case of oil, while global consumption today is about 85 million barrels a day, the spare capacity in the world is only about 2-3 million tonnes a day. One attack in Nigeria, or one storm in the Florida Keys would lead to a shortage in supply.

And like I pointed out, elasticity is not just about price setting the supply. Sometimes, supply sets price. As there is no feasible substitute product for oil, the elasticity of oil is very low, maybe as low as 0.1. Let us now evaluate a hypothetical situation, where the supply oil drops by 1%. And lets see what happens to price.

Now, from the formula, Price Elasticity (0.1) = Percentage change in supply (0.01)/Eq. Change in price

Cross multiplying Eq. Change in price = 0.01/0.1 = 10%.

Now, we see the problem. The smallest supply disruptions lead to a HUGE change in price. Now, over the last 20 years, oil demand has increased by about 20%. Even if supply rose by 10%, the gap in demand and supply is still 10%. With a price elasticity of 0.1, you can see that the resultant change in price is at least double. If you add an inflation rate of about 5%, you can see that a rise in oil price from $18 to about $ 70 dollars seems reasonable.

Of course, oil is ruling at quite a bit more than that. Its at close to $90 today. And this is where I inject caution. It would be tempting for me to lower the price elasticity of oil still further and get the required $90 per barrell as the price that oil should be at. But that would not be accurate. In reality, the additional 20 odd dollars is the risk premium of oil owing to the Very small amount of spare capacity and low price elasticity of oil. The market knows that if oil supply just drops by 5% the price of oil could well go up 1.5 times. And disruptions to supply are rather high probability events these days! Some amount of the oil price today is therefore exaggerated to take into account this risk. But to assume that prices will drop to the levels of the early to mid 90′s once the security risk is removed is to live in a fools paradise. Unless substitute products are discovered, or far more reserves than are currently available are discovered and utilised, high oil prices are here to stay.

So there you have it. How price elasticity can be used in the real world with oil prices. This pretty much completes the Price elasticity section that I had. Hopefully, next section onwards will be on some other topic!

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