Friday, November 9, 2007

Flexable Oil

In the realm of commodities, oil is extremely unique. Unlike the precious metals or pork bellies, oil provides us with cost effective transportation, thermal energy to heat our homes, and a matrix for the creation of seemingly endless consumer products. Succinctly put, it provides our economy with the necessary lubrication to transition each day smoothly into the next. Due to this dependence, it appears that the average consumer and ExxonMobil(XOM) will remained joined at the hip. Why then, with brent crude trading in the $90 range haven't the markets thirst for oil been slaked, or the consumers appetite to spend been squelched?

In physics, elasticity is defined as the physical ability to return to an initial form or state following deformation. For economics, elasticity can be understood with a similar methodology. Price elasticity is the responsiveness of quantity demanded or supplied with respect to price changes. In other words, how likely is demand or supply for a good or service going to respond following a deformation in price.

For items such as normal and inferior goods, price fluctuations correlate to a reflected increase or decrease in the quantity demanded by consumers. These goods, such as computers and cars are considered elastic as the quantity demanded changes substantially with these pricing gyrations.

Inversely, goods such as cigarettes are largely considered inelastic. Graphically configured, inelastic demand for cigarettes would appear as a nearly vertical line on a demand curve i.e. as price increase, demand remains relatively unchanged. Some argue that this inelastic nature is skewed as nicotine is a physically addictive substance requiring progressively greater concentrations by the user which supports demand regardless of underlining price. Additionally, cigarettes remain inelastic because no readily apparent substitute exist. This further prevents consumers from switching products in response to price changes.

Computers, cigarettes and consumer staples make sense, but what about oil? How can the price of oil increase 500% in a decade without dramatically stifling demand? Odiously to some extend, oil must be inelastic. However, to accurately determine the effect of price on demand for oil, price must be correlated with time. Throughout recent history, oil has demonstrated instances of inelasticity and bouts of elasticity as during the 1970s-80s oil shocks. The importance here is not so much price, but price with respect to time.

Oil as Elastic

"From 1980 to 1981, the price of oil went from $11 to $35 per barrel. World oil consumption fell from a 1979 high of 51 million barrels per day to less than 45 million in 1985." Prices rose rapidly, and demand was squelched. During this move consumers were shocked by a 1 year, >100% price undulation. Consumers were unable to adjust personal lifestyles rapidly enough to compensate for the price increase. Additionally, suppliers were unable to subsidize refining capacity with alternative sources such as biofuels or new oil streams.

As a result of the 1980-81 shock, demand was suppressed. The elasticity of oil can also work in reverse as we saw during the 1990s. Decreased consumption in the 1980s and an increased in non-OPEC production from 15 million barrels in 1977 to 24 million in 1985 resulted in price stability in the range of $18-20. This depression of price encouraged many Americans to purchase gas-greedy SUVs during the 1990s economic expansion.

Oil as Inelastic

Even with a greater than 500% increase from 1996 to 2007, oil is still relatively cheap. According to economist Nigel Gault at Global Insight, "at $3 a gallon, it costs Americans only about 4 percent of their disposable income." With these prices, the consumer is capable of absorbing the price differential. More so, the consumer has had sufficient time to adjust life styles accordingly. Until now oil's upward accent has had limited effects on the average consumer. During the third quarter the economy logged its best performance in over a year and a half as the gross domestic product expanded 3.9%. This slow but deliberate progression has allowed consumers to buy more energy efficient cars, upgrade home heating systems and yes, even car pool. We are paying more for gas than we were a year ago, but we are able to do so with out significantly altering our spending patterns.

There however could be an inflection point. Eventually, either through price shocks, the emergence of alternatives or even a recession, demand for oil could decrease. Until that point, demand and prices remain high as the EIA expects consumption to grow by 14 million barrels per day from 2004 to 2015.

I am reminded of an experience just last week, where I actually had to wait at the pump for biodiesel. This scenario had never happened to me, and in retrospect it dawned on me. All of these consumers are waiting for biodiesel; not to be green, or to support our farmers, but simply because it is now selling at a discount to petrodiesel.