Oil Price Elasticity

The volatility of oil prices is inherently tied to the low responsiveness or "inelasticity" of both supply and demand to price changes in the short run. Both oil production capacity and the equipment that use petroleum products as their main source of energy are relatively fixed in the near-term. It takes years to develop new supply sources or vary production, and it is very hard for consumers to switch to other fuels or increase fuel efficiency in the near- term when prices rise. Under such conditions, a large price change can be necessary to re-balance physical supply and demand following a shock to the system.

Given the past history of oil supply disruptions emanating from political events, market participants are always assessing the possibility

These connect the spot price of oil today to the value that market participants expect the price to be in the future. Just as the current price of a stock reflects what people expect about future earnings, making the actual change in stock prices very difficult to predict, the current price of oil should reflect expectations of future fundamentals, making changes in the price of oil hard to predict. The broad movements of the price of oil and oil futures contracts are consistent with these theoretical restrictions. The price elasticity of demand for oil (that is, the response of the demand for oil to changes in its price) is challenging to measure but appears to be quite low, Hamilton writes, and it seems to have declined over time. Income elasticity (that is, the response of the demand for oil to changes in income) is easier to estimate: for countries in an early stage of development it is close to unity, but it is substantially less than one in recent U.S.

This theory describes the long-term rate of production of conventional oil and other fuels. It assumes that oil reserves are not replenishable. It also predicts that future world oil production must inevitably reach a peak and then decline as these reserves are exhausted. Like every other theory of any importance it is highly controversial. "When will the Oil actually start to run out" is the big question.

Common substitutes here may include natural gas, solar, or nuclear energy sources. The purpose of such a substitute is that one source may be just as useful for the other source in terms of economic scarcity. When scarcity occurs, price may become less important for substitute goods; whichever good is more plentiful and can meet current demand may be the best alternative.

Oil Supply and Demand

The oil markets are unusual in the short term; both demand and supply are highly inelastic. Irrespective of what petrol costs, your car cannot easily switch to another fuel. Ships and airplanes cannot move from diesel oil and kerosene for their propulsion. If it’s freezing cold and you need to heat your house, the only option may be to pay more for heating oil. Likewise, if the price of oil was to halve, you would not drive twice as far, or turn the thermostat up from 22 to 44.

The result is that the short-term demand curve looks like this:

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