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Energy Economics Clarfication and Resources
Posted: July 14, 2008
The following is a copy of an email response I drafted after I was contacted by an analyst wanting to understand more about the economics of oil and global demand. It is my hopes that it helps clarify some of the concepts that I poorly attempted to cover in the webinar:
I was going too fast the other day and didn’t have enough diagrams so the economics portion was muddy. I’m glad you are asking questions.
My basic take on it is that the whole world needs oil – especially the US and China. As demand increases, all things being equal, then prices rise. If the US will not pay $142/bbl for oil then a producer can readily find buyers in another country that will. If the a country sets maximum prices (price caps), then producers will simply sell oil to higher bidders and the country will find itself short of fuel (which was discussed in Friedman’s Freakonomics book).
Some blame speculators on the price of oil but there are also a lot of people that say speculators aren’t to blame. As an FYI, investors bet that oil will continue to rise and are buying futures that are also driving up prices. A “future” or “short sell” is one where a person sells a commodity today with a promise to deliver it later. The seller then books the revenue and has X amount of time to actually deliver a contract or the physical product within which time he/she is hoping that the cost of oil will god own.
Next, as oil goes up, then so do the prices of replacement products. “Oil is very expensive so I will use coal instead.” Not to mention that oil is used to transport just about everything.
Third, energy demand is going up all over the world. After the first oil shock in the 70s, companies shifted from using oil to produce energy and moved predominantly to coal (it is the #1 fuel for electricity) with nuclear, hydro and natural gas also being fuel for production. Again, supply and demand at work. Coal is produced in a number of regions of the world, including the US, and then shipped all over the world. As demand increases, the prices rise.
From the supply side, energy producers can not create new generation facilities fast enough plus they are very expensive. As a result, supply can not perfectly react to increases in demand, which also ensures that prices rise. As utilities strive to bring more generation on-line, they incur costs that they must then charge consumers (and/or governments) to recover.
Specifics on the world market for oil:
Links to supply and demand economics, which can give some basic insight into what is going on – economists use much more sophisticated models:
The demand for oil and energy also tends to be relatively inelastic in the short-term so that is another economics concept to review:
Discussions of energy consumption in the world.
There is a ton of information on the Internet. Fortunately, this is a topical area where a lot of reference material exists.
In general, my newsletter has a lot of energy topics also as of late. Archived editions are online at: http://www.spaffordconsulting.com/dailynews.html
I hope the above helps. If you still have questions, please contact me at george.spafford@pepperweed.com.
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