Sunday, 8 May 2016

The Demand and Supply for Oil

I have quite a number of Oil & Gas (O&G) stocks in my portfolio. Yet, I never go and find out how do the demand and supply curves for oil look like, until Jan this year. The demand and supply curves would provide a clear picture of the territory upon which the battle of O&G would be fought. I always thought that demand would be inelastic while supply would be elastic. It turned out that I was wrong. This is the model that I managed to find on the internet (source: Energy Matters).

Fig. 1: Demand and Supply for Oil

The various coloured dots represent the actual oil production in the world at different points in time. A curve is fitted through the dots to form the supply curve for oil. The demand curve for oil is conceptual only and is shown by the 2 sloping straight lines, representing the demand at 2 different points in time. Readers are strongly advised to read Energy Matters' blog post to understand how the supply curve was worked out.

As expected, the demand curve is quite inelastic, i.e. a large increase in the price of oil would only result in a small decrease in the quantity demanded for oil. The supply curve, however, has 2 parts. The first part has a fairly gradual slope. At this part, the supply for oil is quite elastic, i.e. a small increase in the price of oil would result in a large increase in the quantity supplied. The second part has a fairly steep slope, which means that the supply is quite inelastic, i.e. a large increase in the price of oil would only result in a small increase in the quantity supplied. The point of inflexion from the elastic part to the inelastic part is around USD35.

The demand and supply curves help to explain the historical movement in oil price.

Fig. 2: Historical Oil Price

As shown in Fig. 2 above, oil price has been very volatile since 2004, rising to as high as USD140 per barrel in 2008 and falling to as low as USD30 in 2009 and in Jan this year. If you refer to Fig. 1, most of the price action during this period took place above the inflexion point of USD35, where both demand and supply for oil are inelastic. When both demand and supply are inelastic, a small change in either the quantity of oil demanded or supplied would result in a large change in the price of oil, hence, explaining the high volatility of oil price during this period. It also explains why oil price could fall from USD110 in Jun 14 to USD28 in Jan 16 so quickly and by so much in the last 1.5 years.

Despite the current doom and gloom on oil price, there is a silver lining in Fig. 1. There is an inflexion point at around USD35, below which the supply for oil becomes elastic. When oil price continues to fall along this part of the curve, producers will have to cut back production by more as it is no longer profitable to operate some of the higher-cost oil fields. The more oil price falls, the more producers have to cut back, eventually establishing a new equilibrium.

When oil price fell to USD28 in Jan, there were talks that oil price could fall to as low as USD10! Is this possible? Yes, because in the short term, speculation and herd mentality could force oil price to any price. However, is this sustainable? Looking at Fig. 1, if oil price were to stay this low for a prolonged period of time, producers would have to cut back drastically. In the medium term, fundamentals will take over and lead oil price to a higher, more sustainable level. 

Currently, US shale oil producers are cutting back production, which is one of the reasons why oil price has recovered from USD28 to USD45. Would oil price go back to the good old days of USD80 and above? If you look at Fig. 1 again, both demand and supply are inelastic above the inflexion point, so it is not improbable. It might seem highly unlikely that oil price could return to such lofty levels again, but neither did many people believe that oil price could fall from USD110 in Jun 14 to USD28 in Jan 16. The demand and supply curves show that anything is possible. The model, assuming it is accurate, provides a map of the territory that oil price will move.

A word of caution: even if oil price were to recover to higher levels, it does not necessarily mean that good business will return to many of the O&G companies. There is a difference between oil price and the economics of O&G companies. Understanding this difference can mean the difference between survival and annihilation in the battle of O&G!

Another word of caution: I am no expert in O&G. I am only an investor trying to work my way out of the O&G mess in my portfolio. It is a battle that I have no confidence of winning.

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  1. Chin Wai,

    You are one of favourite bloggers. Always so much substance over "plain talk". Really appreciate the info u put up.

    Indeed like wat u mentioned, while price of oil change in general benefit O&G companies, the economics is different from different segments of the entire O&G chain.

    Eg oil increase will benefit more for State owned and International oil companies like Petronas, Saudi Aramco, Exxon, Shell, Chevron etc...

    Then oil co being nearer to some kind of a monopoly situation will have to decide if they are going to pass these increased profits to companies down the chain via their investment horizons and how much they willing to pay for oil contractors or oil service co!

    1. Hi Rolf,

      Thks for your compliments. I'm only trying to figure out the O&G story for myself. No blogger understands the O&G story better than you!

  2. understand does not mean u can make money out of it. It's just like if u understand ur wife, does not automatically means u can live with her in harmony. LOL

    1. That's true. But at least understanding means we won't be surprised by it.