Oil at $300 Barrel: is this realistic

Oil being one of the most difficult commodities to price, there is plenty of speculation on the price, when there are potential supply shortages. Recently there have been many analyst reports speculating the price for a barrel will top S300 within next five years, due to current Middle East crisis and the surge in demand. Below is an excerpt from a recent analyst report, predicting oil price will hit $300 barrel. This is followed by an analysis of model used for predicting oil price and few lessons learnt on the price elasticity of oil. A "Model" of Chaos The Middle Eastern and North African (MENA) countries produced 22.7 million barrels per day in 2010, rather more than U.S. consumption. However, two of those countries can be left out of the equation. Iran already is run by radicals - any change there would be an upgrade. And Iraq is a democracy that's host to 50,000 U.S. troops; one must hope that a regional collapse would pass it by. Realistically speaking, even if run by radicals, Middle Eastern countries will not stop exporting oil; they need the money. And it won't even matter if these countries refuse to export to the West: If their oil goes to China, India or elsewhere, it will simply be a substitute for - and therefore free up - oil that had been coming from other regions. Now I will concede that a wholesale change to economically inept regimes in the Middle East will lead to reduced output. For instance, when the Shah Mohammad Reza Pahlavi was ousted in the Iranian Revolution of 1979, output fell from 6 million barrels a day to 3 million - a 50% decline. A decline of a similar magnitude seems a reasonable assumption for Middle East countries that succumb to radicalism. If all of them except Iran and Iraq went radical, that would reduce global energy output by 9.9 million barrels per day - or 11.4% of last year's total world output. It used to be very difficult to figure out how much price effect a supply shortfall might have, but fortunately we now have a "control experiment" to use as a model. I'm talking, of course, about the record-oil-price spike of 2007-08.

A Calculated Impact Between the summer of 2007 and its successor in 2008, oil prices rose by 70% while U.S. consumption fell by 4% (when the year's modest economic growth is corrected for). That means the "price elasticity of demand" - an economic term that measures the responsiveness of buyers to a change in price - is about 4/70. Plug that figure back into the supply shortage of 11.4% and you get a price increase of about 200% (Output Reduction of 11.4% x Price Elasticity of 70/4 = Price Change of 200%). In other words, were we to have a "worst-case scenario" revolution in the Middle East, we would be looking at the current price of oil (about $100 per barrel) increasing by 200% - to about $300 a barrel (Current Price of $100/Barrel + 200% Increase = New Price of $300/Barrel). You can quibble with the exact number: Europe has higher gas taxes than the United States, so would see less of a drop in demand than we would; emerging-market economies, on the other hand, are much poorer, and might well see an even-bigger drop-off in demand, perhaps even returning to bicycle transportation. Even so, our $300-a-barrel estimate feels like a good round number that's backed by logic and a certain economic soundness. Under such a scenario, we'd be looking at U.S. gas prices of about $9.57 a gallon - up from the current $3.19. The cost to the typical motorist - who uses about 500 gallons of gas - would be an additional $2,700 (assuming that his usage declined by 11.4%). (Hutchinson, 2011)

Is this realistic?
Analysis of the control experiment

Summary of calculations for the control experiment: Using a supply drop of 11.5% and US demand drop of 4 % and price rise of 70% during 2007-2008 period

Plugging in above numbers to the formula, Elasticity = 70/4 % Change in Price= Price Elasticity X %Change in Quantity 200 = 70/4 * 11.5 US Demand -4% Supply Drop 11.5% US Price 70% Elasticity 70/4 Elasticity 70/4 Price Increase $ 201

The Control experiment ignores the supply and demand dynamics due to price changes; these factors radically change the oil price. The model extrapolates demand for oil at $300/barrel using its current price elasticity of demand. Oil is relatively price inelastic, overall demand for oil will not decrease that much with price rises. Analyst uses the current price elasticity of demand to estimate a future price ,based on Middle East supply disruption and panic. One of the problems with this methodology is that the price inelasticity of demand would likely radically shift for oil once it hits a certain level. I.e. At current prices there are no substitutes for oil, at $250 or $300 alternative technologies and substitutes will have more value and consumer demand will shift down. Also the analysis ignores the fact that oil would become much more price elastic at higher price levels. Whats more is in the short term supply would also increase at higher price levels. Due to above factors its highly unlikely that oil will reach $300 within five years. Lesson 1: Oil price is highly sensitive to supply dynamics

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.

Plugging above changes the numbers in to above equation, 0.1=%Change in Price/0.01 Price Elasticity 0.1 %Change in Demand 0.01 %Change in Price 10%

1 % drop can increase the price by 10%, smallest supply disruptions lead to a huge change in price. Today the oil prices include a high risk premium due to high probability of supply shocks.

Lesson 2: Is Short term Oil price elastic on inelastic?

Oil is an essential good and in the short term oil price is inelastic. Analyses of short term data for 2008-2010 show, even with real price rises; oil consumption has risen and predicted to rise.

World Consumption and Oil Price(West Texas Crude)

millions of barrels per day 92 90 88 86 75 84 82 80 2008-Q1 2009-Q1 2010-Q1 2011-Q1 2012-Q1 55 World oil consumption (left axis) WTI crude oil price (right axis) dollars per barrel 115

95

35

Source: Short-Term Energy Outlook, March 2011 Lesson 3: Is Long term Oil price elastic on inelastic

In the long run demand for oil and price should be relatively elastic. At higher prices consumers will look for substitutes. During recent oil price surge and GFC there has been drop in some consumer demand for oil i.e. using public transport and greener technologies. But analysis of long term data show increasing demand for oil with rising prices. This is a contradiction to the intuition above. This is mainly due to High economic growths around the world and people are willing to pay more because of the economic growth. If real incomes remained constant, higher prices would reduce the demand, but generally real incomes rise. Also reduced demand in some parts of the world is offset but economic and income growth.

Nominal and Real Oil Price

200.00 180.00 160.00 140.00 120.00 100.00 80.00 60.00 40.00 20.00 0.00 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Nominal Price Real Price

Source: BP Statistical Review of World Energy June 2010

Oil Consmption and Real prices

90000 Consumption(Thousand Barrels Per day) 80000 100.00 70000 60000 50000 60.00 40000 30000 20000 20.00 10000 0 0.00 40.00 80.00 Real Price 120.00

Source: BP Statistical Review of World Energy June 2010

Works Cited
Administration, U. E. (2011). Short-Term Energy Outlook. Washington, DC 20585: U.S. Energy Information Administration. Hutchinson, M. (2011). This Middle East Meltdown Will Send Oil to $300 a Barrel and Pump Prices to $9.57 a Gallon. Retrieved from Money Morning: http://moneymorning.com/2011/03/02/middleeast-meltdown-will-send-oil-to-300-barrel-pump-prices-to-9-dollars-per-gallon/ June, 2. B. (2010). BP Statistical Review of World Energy June 2010. London: BP Global.