Tight balance between supply and demand can lead to high prices that cause both higher expenditures for consumers and higher incomes for producers. In economics, exhaustible resources generally follow the rule that the rate of growth must equal the rate of interest in order to reach industry equilibrium. However, due to the unpredictable character of future oil supply and demand conditions, oil prices do not generally follow this rule. Most of the time, it exhibits backwardation wherein future prices are lower than current ones. Future demand is hard to predict because it is difficult to foresee changes in energy technologies and it takes years for consumers to switch to other resources should prices go off the roof. On the other hand, investment is expensive and risky and it takes a while before production supply turns to high capacity. Oil prices also behave unexpectedly since the market is responsive to speculative pressures, operational constraints, and political conditions.
The Hurricane Katrina, by reducing gasoline supplies (which is chiefly derived from crude oil), became one dramatic factor that caused oil prices to skyrocket in 2005. The storm reduced oil production, transportation and refining capacity--it paralyzed major oil and gasoline pipelines that carried supplies down from the Gulf Mexico and took down offshore oil platforms. Power outages also caused problems in oil and natural gas distribution in many areas. The large drop in supplies caused oil prices to rise. Additionally, consumer expectation contributed to the demand component. With the hurricane retarding oil production and restricting supplies, they expected prices to rise. They immediately increased the demand by buying gasoline, hoping to fill up their tanks before prices start to rise. Reduced supply and increased demand caused oil prices to increase dramatically, as shown in the graph below:
3. Analyze the structure of the world oil market & identify what kind of market structure it has.
The world oil market structure is oligopolistic, since the market is dominated by a limited number of suppliers. An industry is said to be oligopolistic if few supply the majority of the output and if those suppliers are interdependent. In oil production, about 50 percent of the output and 70 percent of the reserves are controlled by a cartel. Production is handled by both public and private sectors. However, oil production is just one aspect of the market-converting and refining it to other consumer products is another facet of the total world oil industry, one which has its own dynamics and regulations.
Worldwide supply and demand determines oil prices, with great influence from OPEC. On the supply side, OPEC provides most of the world's supply and normally acts as a semi-cartel, influencing oil prices by maintaining excess capacity. It also tries to maintain oil prices at its target level by setting quotas or production limits for its members. On the other hand, non-OPEC suppliers have generally limited reserves and typically behave as price takers. OPEC's policy in recent times is to control crude oil inventories and reserves in consuming nations in order to balance the market.
4. Use separate demand & supply diagrams to show the