Oiled up

Great question, Killer B! I like and respect you as well.

Oil price movements in the last year have left a lot of people scratching their heads. I’ve read almost nothing intelligent on the matter. Some members of the media and more than a few politicians seem to think speculators are to blame. Killer B is right to disregard that notion. Speculators do indeed increase demand for oil by buying contracts to take possession of oil at a later date. However, since they don’t actually want to take possession of a bunch of oil, they need to sell those contracts before they expire. Buying and selling an equal number of contracts pushes out the supply and demand curves equally. No effect on prices.

The shapes of the supply and demand curves tell a much more interesting story. The demand curve we learn in Micro 101 is a straight, upward-slopping line, meaning the more a product sells for, the more of it manufacturers will produce. But oil’s supply curve isn’t a straight line. Like every commodity, oil’s supply curve is based on the cost of production. The graph below is illustrative if not accurate, but something like 90% of the maximum daily output can be had for pretty reasonable prices. After that there is a sharp inflection point. Marginal sources become much, much more expensive to turn on. Oil shares this shape with nearly every commodity with limited storage (natural gas, electric power, etc.):



For many products, this shape exists, but is not a daily part of our lives because the demand curve crosses somewhere far away from this kink in the supply curve. The Micro 101 demand curve is a downward sloping straight line, meaning that as prices for a good rise, the quantity purchased falls. Oil is a bit trickier. Over long periods of time, oil has a downward sloping demand curve. People buy smaller cars, figure out the bus schedule, move closer to work, etc. But in the very short term, there is very little the world can do to use less oil. The demand curve in the short run is thus a vertical line, shown below in red:



The price we pay and for the quantity we demand is shown at the intersection of the supply and demand curves.

Now here’s the fun part. Both the supply curve and the demand curve move around from day to day and year to year. What we saw a year ago was the supply curve squeezing in due to supply disruptions in Iraq and Nigeria, along with natural decline in Norway, Mexico and other places. At the same time, the demand curve was pushing out due to a growing Chinese middle class and economic expansion in the West. The new graph looked like this:

Over the past few months, a global recession has brought the demand curve back in. A bonanza of oil infrastructure investments made over the past decade has come on line, pushing the supply curve out. The combination has crushed prices:

This explains 90% of the movements we’ve seen. There are other things around the edges, like government policy and the relative strength of the US dollar, but those aren’t as important.