A model for exploring oil boom & bust cycles

Economics 101 starts with a stylised depiction of a supply and demand curve. The price is determined by the intersection of the curves. This implies that there is no such thing as an ‘oil supply gap’ since a shift of the supply curve leftwards will simply result in a new equilibrium price and the market clears.

UBUfx

But what about oil? Mathematician and economist Jim Case gave a presentation at a recent BioPhysical Economics workshop titled ‘Hotelling Revisited’ in which he explored the historic price of oil.

In contrast to the stylised fact of supply and demand, Case argues that oil is much like many other products and services in being far from scarce, and not conforming neatly to a supply-demand function. Of course oil is finite but for nearly the entire history of oil supply, there has been spare capacity that can readily be called upon, and therefore the price is rarely set by the equilibrium price. If not the equilibrium, then what? By oil cartels of course.

Case notes that –

… many genuine essentials are far from scarce. Because common labor is not scarce, we have minimum wage laws; because agricultural produce is not scarce, we have farm price supports; because crude oil is seldom scarce, we live with oil cartels.

Prior to cartel behaviour, the oil price was highly volatile, with boom-bust cycles sending oil producers broke. Texas lease holders were frequently going broke selling ‘Black Gold’.

oil prices historic

John D. Rockefeller imposed market discipline by forming the Standard Oil Trust, which ran until being found in breach of antitrust laws in 1911. At that time, the trust held 70% market share of the refined oil market. As motor vehicle growth began to slow in the mid 1920s, order was re-imposed. In 1928, an historic meeting of the ‘7- sister’ oil companies took place at Achnacarry Castle, Scotland (held in Scotland because it would have been illegal on US soil). A few years later, the Texas Railroad Commission (TRC) was called upon to ‘preserve the order’. For the next 40 years, the TRC used its authority to limit production, at times to as little as 3% of rated well capacity, or a single ‘producing day’ per month. In 1973, OPEC took over from the TRC. Only occasionally ― since 1882 ― has crude oil been scarce enough to command a stable price. Interestingly, the recent lack of OPEC discipline has led to an oversupplied market and prices set much closer to what one would expect from Econ 101.

Case argues that cartel behaviour has been the only means to constrain wild swings in price. Volatility creates uncertainty in the demand market, and bankruptcies in the supply market. Since demand is highly inelastic in the short-run (i.e. nearly vertical), the case of demand bumping up to supply constraints leads to wild swings in price.

Jim finished with a stylised depiction of ‘an alternate model’ for predicting oil price – the endpoints represent a stylised demand function in which demand tends towards zero at some hypothetically high price, and towards saturated demand at some low price. The bottom curve represents the boom phase, the upper, the bust phase. The price can shift inelastically for a range of volumes, but the price can also ‘short circuit’ by panic during the decline phase. The takeaway is that price projections are fraught given the wide variance between the boom and bust curves and that we should be thankful for rational cartel behaviour.

 

Case alternate model

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