What happens when there is a supply-demand imbalance in a market with very low demand inelasticity, like oil?
In other words, how high should the price of oil rise to cause a drop in demand sufficient to clear the market in a situation where supply is contrained by physical and/or political factors?
The case of molybdenum, a metal which also displays low demand inelasticity, offers an interesting insight:
Prices multiplied by 10 or more is what is required…
(Thanks to mobjectivist, via Pedro in the comments)
Whale Oil is another interesting precedent for price predictions.
Molybdenum is a metal which is used in steel production. Since 2002 supply demand balance swung to the demand side. The demand has outgrown the supply.
This deficit has had some very interesting consequences for the price. over the past three years the price of molybdenumoxide has increased from $2 to $28.50, a fourteenfold increase . Since the speculative position on this market is relatively small we can assume that these prices reflect the real supply demand fundamentals. It is staggering to see how a relatively small supply shortage can lead to these enormous price increases. It really shows how inelastic these markets are.
I think the steel market and the oil market are fairly comparable when it comes to inelasticity. If so then this is what we can expect for oil when the market runs into a deficit. The price increases we have seen so far are nothing compared to what is going to happen.
If moly is of any guidance we can expect the price to suddenly double, triple or quadruple when a real shortage occurs. That is a pretty scary thought.
As I have argued in several previous posts, we are indeed entering a situation in the oil market where we have a serious risk that there will not be enough supply to satisfy all potential demand:
– demand keeps on increasing (and shows how inelastic it is: since 1999, prices have already been multiplied by 5, and yet demand has increased in every single year, and by record volumes in the past 2 years);
– additional supplies are becoming increasingly scarce, as mature fields see their production decline and not enough investments are made to develop new fields. (Note that I do not personally think this is due to peak oil – this is in my view due to lack of investment – the oil majors would invest but have no access to most of the reserves in closed countries, and these countries seem more intent to spend their oil bonanza than invest in new capacity). OPEC has slowly put in production its existing spare capacity and has nothing left now.
The recent reaction of the markets to the recent quota increase by OPEC shows that the traders believes the same: the increased production does not bring the price down because it is taken from the last cushion of available, and will not be sufficient if demand increases a tad more or if there is a disruption to production anywhere (weather event, strike, accident, terrorist attack, political decision by any producer to withhold production…)
We are living on our last emergency batteries currently (until more investment is made to develop untapped reserves, but that will require a few years). Prices have been multiplied by 5 since 1999, to no obvious effect; if we take the example of molybdenum, if will require another tripling of prices to have any effect; but if we consider that oil prices were in the 15-20$ range in the 90s, it will require another 5-fold increase (and we have no real way to know how relevant the example of molybdenum is – after all its consumers are industrial users that are mostly rational, not citizens with a "God-given" right to drive and travel…).
For once, I won’t leave you on this gloomy note but will point you to another interesting historical precedent for oil : that of whale oil, the only commodity to have gone through a full Hubbert’s peak cycle:
The "bell-shaped" production curve of a non-recyclable mineral resource was described first by M. King Hubbert in 1956, and was used to correctly predict that the production of crude oil in the United States (Lower-48) would peak in 1970. It is reasonable to suppose that the worldwide production of crude oil will also follow a similar bell-curve, with much of the present debate focusing on when the peak will occur. It is anticipated that it will generate an epochal change deriving from a steep rise in prices.
The rise in prices at the peak is expected because of the switch from a market driven by production to one driven by supply. The Hubbert model, however, does not itself provide quantitative information on prices, and it is not possile to draw conclusions from individual country peaks because oil prices are set globally.
In order to obtain historical evidence for price trends, one needs to examine a case where a non-recyclable resource went through a complete Hubbert cycle worldwide. There are no previous examples of a mineral resource that has done so. In fact, crude oil may turn out to be the first, which incidentally may be one of the reasons why the concept of "peak oil" is so difficult for many people to grasp.
A resource does not need to be a mineral one to show a Hubbert curve. A biological resource which is produced (or "extracted") much faster than it is replaced may also follow a bell-curve. Historically, there have been several cases of terminally depleted biological resources. The whaling industry of the 19th Century is a good example, as already noted by Coleman (Non Renewable Resources, Oxford University Press, 4(1995) 273).(…)
From the figure [above], it is evident that the production of whale oil followed a bell-curve according to Hubbert’s theory, modelled with a simple Gaussian curve, albeit showing strong oscillations. These data are in excellent agreement with the report on Right Whale abundance by Baker and Clapham (Trends in Ecology and Evolution Vol.19 No.7 July 2004), indicating that the fall in production after the peak was caused by depletion and not by the switching to different fuels.
(…)
we can derive insight into crude oil price trends from the figure. Whale oil prices started to increase approximately at the inflection point of the curve well and before the production peak. An upward spike in prices took place a few years after the peak, being also detectable in the non-inflation corrected price data (see Coleman, ibid.).
There are good news:
A somewhat surprising result is that the inflation corrected prices remained approximately constant after the peak despite the progressive depletion of whales.
But this may not be the most important:
If, as often claimed, we are close to the peak, and if the analogy with oil production holds, we may expect a further sharp increase in prices in the coming years, a trend that may, actually, have already started in 1999.
(…)
The concept of the terminal depletion of a mineral resource is alien to us, since there have been no worldwide precedents. In addition, we are apparently just near the midpoint on the production curve, so we still have to experience the peak, the associated price rise, and the decline.
Put simply: the uncertainty is so great, and the impact likely to be so big on our economies (if only from the wild oscillations of the price) that it is criminal not to plan for this, and not to be actively seeking alternatives.
Terri Schiavo is not the only one to be Brain-Dead.