Abstract

Oil prices rarely reflected those of a free market. The history of the oil industry documents several instances of monopoly and price fixing. In the last decade however, globalization and the ensuing economic policies raised the possibility that the oil market may finally be free from production and price controls. This paper will analyze the oil supply and demand patterns under scenarios of free market and will predict short and long-term price patterns under these conditions.

Introduction

It is very important to know the direction of oil prices in the future since these prices have shown to have considerable effect on the economic health of both the producers and consumers. It appears that the interests of the two parties are in conflict, and that it is imperative if one side is to gain the other must lose. As a result of this conflict of interest the oil market has been plagued by interference from both sides and was never able to function as a free market. Recently however, particularly following the end of 1991 Gulf War and the collapse of the centrally planned economic systems, the oil market has been more in tone with the classic supply and demand behavior. Although the Organization of Petroleum Exporting Countries (OPEC) is still very influential, OPEC as a group has been showing more tolerance to market forces. In this brief study an attempt is made to analyze the behavior of the oil market when the forces of supply and demand are in effect.

The Present

If we represent a free oil market by the classical supply and demand curves shown in figure 1, it can be clearly seen that at equilibrium the quantity consumed is Qe at a price Pe. Since the oil market is not a free market, i.e., the producers are not free to produce as much as the market demands, the quantity demanded and the unit price do not coincide with those of equilibrium. Ignoring the effects of consumer interference — such as gasoline taxes and the widely publicized carbon tax — on the oil market to simplify the analysis, and returning to our supply and demand curves, we can hypothesize that we are not at market equilibrium, and that the quantity demanded is some restricted value Qc at an artificial price Pc higher than Pe. Clearly Qc includes both Non-OPEC and OPEC supplies, that is, Qn and Qc - Qn respectively. In figure 1, aggregate supply is marked AS, curtailed supply is marked CS, and the non-OPEC supply is marked NS.

Another feature of the supply curve is the "choke price" defined as the price at which supplies will be zero. This price is different for OPEC and Non-OPEC (Pm <Pmn) where Pm is the "choke price" for OPEC and Pmn is that for Non-OPEC. This is due to the fact that production costs per barrel is lower for OPEC than Non-OPEC. Clearly OPEC supplies will continue to enter the market even if oil prices drop to Pmn at which Non-OPEC supplies will no longer be economically feasible.

To summarize the present status of the oil market, it can be said that the market is not situated at the equilibrium position, and that the quantity supplied is less than what would be demanded in a non-restricted market. There are two supply sources in competition over market share, one source is essentially unrestricted (Non-OPEC), and the other is acting as a swing supplier (OPEC) and supplies whatever Qc- Qn is. Currently the market is deprived from the quantity Qe- Qc to maintain a price differential of Pc - Pe.

The Hypothesis of a free Market

The changing political and economical alliances could force oil producers to minimize or eliminate their interference yielding an oil market that will function as a free market. When interference ceases to exist, free flowing supplies will come to equilibrium with some level of demand. Let us examine what may happen if that occurs. If OPEC ceases to set production ceilings and price limits, all members will be competing for market share with each other and with the Non-OPEC group which will force each producer to supply the quantity that fits their individual economic criteria. Returning to figure 1, the equilibrium point in a free market occurs at the intersection of the aggregate supply curve (sum of OPEC and Non- OPEC) and the demand curve labeled D1. Clearly this situation will lead to an increase in the quantity supplied by OPEC due to their excess capacity and low production cost, which would cause the prices to drop to Pe and OPEC supplies will increase to Qe- Qn. Therefore oil market liberalization will likely lead to an increase in OPEC's market share and a drop in prices below their current levels.

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