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Video transcript
In the last video we explored when you pay a certain amount of money on a per gallon basis at the pump, how does that break down who get what? How much of that goes to the gas station, verses the transportation network, verses the refineries, verses the actual oil producers? The one thing I do want to emphasis is I just use that as kind of indicative numbers. They can change widely based on what's going on in the market, and where we are in the world. They are fairly indicative. The other thing I want you to realize is that they aren't always proportional. It's not like that if oil prices were to double that this 15 cents that the retailer got would turn into 30 cents. In general, regardless of the price of oil, at least in the United States, the retailer tends to get between 5 cents per gallon and 20 cents per gallon. It's normally in that 10 to 15 cent range. Some of that has to be netted against the 5 cents or so that goes for credit card processing. Taxes can be relatively fixed. It's often on a per gallon basis. The spread that the refineries gets, it's also not necessary proportional to the price of oil. There are times where the oil prices very high because their might be a lot of excess capacities at the refineries. Their not able to charge a huge premium, or maybe their not able to get a lot of the other stuff. The refineries might not be able to make much if anything on each barrel of oil that they actual refine. Sometimes it goes the other way around. A low price of oil, if the refining capacity is really tight, the refineries can raise the price of the actual refined oil products. They can raise more and more money. The players in this whole supply chain that do, whose profits are a function of the price of oil are the oil producers. Just to be clear, sometimes all of these are owned by the same company. That's what they call these kind of vertically integrated oil producers. Sometimes they are different players, and when they are different players, the ones that makes the most when oil prices are high are the producers. These producers, they invest huge amounts of money in exploration and then in drilling. They make some assumptions. They say, "Hey, this oil rig that I'm going to spend a hundred or two hundred million dollars on, this is going to be break even if oil prices are say $30 a barrel." Obviously, if oil prices end up being at $100 a barrel, they're going to make a killing. They're going to make $70 per barrel of profit. This thing is going to produce millions and millions of barrels. On the other hand, if oil prices go down to $15 per barrel, they're going to be killed. They're going to take a huge loss on this huge investment they made. The one question I want to at least attempt to address, and it's not a simple question. Many people devote their careers to this. What is actually dictating the price of oil? We see it can't be just the traditional supply and demand, or at least in the short term it can't. If we look here at 2008. In mid 2008 oil prices were pushing $150, and then only a few months later they had collapsed to $32 a barrel. They had gone down by a factor of 5. There is something that happened here. The financial crisis hit, obviously, peoples expectations of global growth would have been gone down. The economy wouldn't grow. People might use a little less energy, a little less fossil fuels, whatever. That wouldn't be enough to justify a 5 fold decrease in the price of oil. Something else is at play. As you can imagine, a lot of it is just going to be the psychology of the crowd right over here or the psychology of market. People were driving up the price of oil, and over here people freaked up, and they started driving down the price of oil. To think about that in a little bit more concrete terms. I mean think about the price, or I'm going to think about the oil markets in particular in the long term and short term, or the long run and the short run. In the long run, let me draw the long run right over here. In the long run we can think of the oil markets like you would think of any traditional microeconomic market. Oil is entrusting because it's a microeconomic. It's one good or service that has huge implementations on the macroeconomy on the growth of nations, how they act, and whatever else. We can think of it in kind of classical microeconomic terms. That's the price of oil. That's the quantity of oil. You can imagine that those first few millions of barrels are fairly cheap to produce, and then every incremental millions of barrels. If you think about this, this is the quantity the millions of barrels per day. They have to go explore finding it harder and harder places, using more and more technology to find it, so the marginal cost of producing incremental barrels goes up. Another way of thinking about this, at a low price, oil producers say, "Hey, I'm going to leave that oil in the ground. Why should I pump it out and produce it now? So there won't be a lot of quantity produce." At a higher price they're like hey, we're going to pump as much as we can. We're going to find that oil wherever it is. We are going to pump it and get it to the market. Two ways to interpret the long run supply curve. Long run supply. The demand, also, we can kind of view it in kind of a classical way. Those first few millions of gallons, a huge benefit to the consumers. There are some people that maybe oil is the only thing they can use. They can't go to any source of energy. They get huge benefits, but then the marginal benefit goes down for every incremental barrel of oil. Another way of thinking about it, at high prices there aren't a lot of people who are interested in doing it. They say,"Thank you. I'll just go use something else. I'll use solar power, I'll walk to work, or whatever else." Then at low prices they say, "Hey. I'm going to use all the oil I can use. I'm going to drive my gas guzzler 100 miles to work. I'm just going to drive it around the block for fun. I'm going to leave it running, because I don't like to start my engine, and all the rest." This kind of gives you a classical model downwards-sloping demand curve, and an upward-sloping supply curve. Then you would end up with some equilibrium price in the long run, and some equilibrium quantity. This right over here does not describe this all too well. Between here and here you did not have dramatic changes in how people ... the amount of oil that supplied into the market. You did not have dramatic changes in peoples behavior in terms of how they consumed, or where they consumed a lot or a little of it. One way to think about it is this is the long run. Think about dynamics in the long run, if there is new technology to find new oil to supply curve could shift to the right like this. If for whatever reason people start driving electric cars, then the demand curve could shift to the left like that. If for whatever reason it became fashionable again for people to drive SUVs, the demand curve could shift to the right. If countries economic growth accelerates, if people in India and China end up becoming wealthier and want to buy more combustion automobiles, it could shift to the right. In the long term you can think about it in that way. If there's more drilling, if there's eases regulation on drilling, you could shift the supply curve to the right. If you increase environmental regulations, supply curve could shift to the left. You could figure out the implications. That's not what's really at play in the short run. When I think about the short run, I'm not thinking about on a second-by-second basis, the short run is really we're thinking on over a period of months or even a small number of years. That's because people aren't changing their behavior dramatically on a month-to-month basis. They already bought their cars. They already bought their gas-guzzling SUVs. Also, it not easy for suppliers to turn capacity on or off in the very short run. In the short run our model might look something like this. Obviously, these are gross over simplifications, but they help us think about it a little bit. This is the quantity. This is price, so in the short run, the quantity supplied is really not going to be too sensitive to price. It might look something like this. I'll just do it as a vertical line just to really state how in the short offering, over a of months, people are just going to pump out the oil that they were planning on pumping on. Their not going to shut wells. Their not going not use their tankers or whatever else to transport their oil. Their going to produce, and it's going to be transported to the market. This is the short run supply curve, regardless of the price. In the long run, if the prices go down they might decided to turn off capacity. If prices go up they might do more expiration, open up more wells, but that takes time. Often years to do that, especially if you start from the expiration phase. This is supply not too sensitive to price. Demand might look something like this. Once again this is one way of thinking about it. A very simple model. Demand might look something ... I'll do it in orange. Might look something like this. Where is goes ... looks something like that. The reason I drew demand that like, is it kind of fits at least people short term behavior. If our price right now is right over here, if it were to pop-up right over there, in the short run, people don't change their behavior that dramatically. Their house and their work is the same distance. It's takes them a while to start thinking about moving a little bit closer, changing jobs, maybe getting a pass for public transportation, or trading in their gas-guzzling car for another car, or car pooling, or whatever else. If prices go down, the other way around. They might still have their Prius. They won't trade it in for a more gas-guzzling car, et cetera, et cetera. What this describes is in the short run the prices aren't being dictated by these classical mircoeconomic inputs or factors in terms of supply and demand. What's really effecting them in the short term is market psychology, and this is why I put a little picture of Chicago Board of Trade. Which is where they trade futures contracts. Futures contracts and I've done video where I go into detail on what futures contracts are. They are a way of trading commodities. Instead of people walking around with vials or barrels of oil and exchanging them, they say, "Here's a contract to purchase oil from me in a month, or at a specific date, or two months at a specific date." People trade those. In the near term, what's really driving the price of oil? What's really causing these fluctuations right over here? That can't really be described by all of these things, is peoples psychology, and peoples information. They look at things like the Middle East. They say, "Will Israel, Benjamin Netanyahu, Israels Prime Minister, decide to preemptively bomb Iran in an attempt to get rid of their nuclear program. Will Iran do something crazy? How would they retaliate? Would they try to close off the straight of our moves?" Even if no one really believes that is happening, some of them might say, Well someone else might believe it." They might buy the futures contracts and then try to trade it up, and other people, eventually, that oil has to be delivered, they might take deliver of that oil but not bring it to market. They might hoard it in some way, because they believe that somethings going to happen and oil is going to be scarce at some point in the future. The big take away is all of these things, the production of oil, other sources of energy, peoples behavior, they do matter in the long run on the price of oil. In the short run, we're talking about the order of 6 months to over a year. It really is market psychology. Some of these geopolitical events that might effect market psychology that's causing these wild swings in the price of oil.