Chapter 38 Energy Prices McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc All rights reserved Chapter Outline • Historical View • OPEC • Why Prices Change So Fast? • What Will The Future Hold? • Kick It Up A Notch McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 38-2 1-2 Real Oil and Gas Prices 2005 dollars Per gallon (1 barrel=42 gallons) McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 38-3 1-3 Historical Events Relating to Oil and Gas Prices • 1972 Arab-Israeli War • US support for Israel prompted an embargo by Arab oil producers against the US and Europe This led to a significant increase in crude oil prices • 1979 Iranian Revolution • Iran’s Islamic revolution led to instability in the Persian Gulf This led to a significant increase in crude oil prices • 1980’s • Rapid increases in profits led to significant discoveries of oil in Mexico and the North Sea • 1980-1988 Iran-Iraq War • The war led to increased production by both parties as each needed to fund their war effort This caused a precipitous fall in crude oil prices McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 38-4 1-4 World Oil Reserves Group Billions of Barrels in Reserve Percentage of World Reserves Persian Gulf 747 60% Non-Persian Gulf OPEC 181 15% Rest of the World 310 25% McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 38-5 1-5 OPEC • The Organization of Petroleum Exporting Countries (OPEC) • Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, and Venezuela • OPEC began as a cartel • A cartel is an organization of individual competitors that join to form as a single monopolist McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 38-6 1-6 Was OPEC a Cartel? OPEC production has always been a significant part of the oil market but it has never reached the level of monopoly The cartel model is still useful because it has been a dominant player McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 38-7 1-7 The Cartel Model Market for Oil P P S=MC One Country’s Oil MC Profit Profit ATC MR’ Pcartel PPC MR D Qcartel MR McGraw-Hill/Irwin QPC Q Qquota QPC Qcheat Q ©2012 The McGraw-Hill Companies, All Rights Reserved 38-8 1-8 Why Oil and Gas Prices Change So Fast • Because expected price is a determinant of supply and demand a world event that causes people to expect a price increase will • Increase current demand (as middlemen and consumers try to buy as much as possible) • Decrease current supply (as middlemen and gas stations try to hold onto their current stocks) • This causes an immediate increase in prices McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 38-9 1-9 Historical Events Relating to Oil and Gas Prices • 1990 • 1992-1998 • 1999 • 2003 • 2004-2005 • 2007 • 2008 McGraw-Hill/Irwin Iraq Invasion of Kuwait OPEC massive overproduction OPEC discipline US invasion of Iraq Hurricanes in the Gulf of Mexico Iran-US tensions; Commodity Speculation Global Financial Crisis ©2012 The McGraw-Hill Companies, All Rights Reserved 38-10 1-10 From $1 to $4 in Ten Years 1) 2) 3) 4) 5) 6) 7) OPEC production cuts; Low stocks of oil; bad weather Release of oil from the Strategic Petroleum Reserve; recession Political unrest in oil producing Venezuela and Nigeria; War in Iraq Hurricanes Damage Platforms in the Gulf of Mexico Threatened Conflict b/w U.S Iran Global Commodity Speculation Global Financial Crisis McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 38-11 1-11 Gasoline Prices 1998-2008 McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 38-12 1-12 Gasoline Prices and Hurricanes A significant portion of refining capacity in the US is in the Gulf of Mexico McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 38-13 1-13 Electricity • Residential electric power tends to be sold by a regulated monopoly • It has been a monopoly because of significant barriers to entry • It has been regulated because prices would be much higher than is socially optimal McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 38-14 1-14 Types of Monopolies • Simple Monopoly: a monopoly in which marginal costs of production are rising • Natural Monopoly: a monopoly in which marginal costs of production are falling McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 38-15 1-15 Monopoly in the Market for Residential Electricity • The market for residential electricity is likely to be a natural monopoly for nuclear power because of the very high fixed costs (transmission lines and the power plant and diminishing marginal costs.) • The market may be characterized as a simple monopoly or natural monopoly for coal or gas generated electricity McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 38-16 1-16 An Unregulated Simple Monopoly MCMonopoly P Pmonopoly MR Qmonopoly McGraw-Hill/Irwin D Q ©2012 The McGraw-Hill Companies, All Rights Reserved 38-17 1-17 An Unregulated Natural Monopoly P Pmonopoly D MR Qmonopoly McGraw-Hill/Irwin ATC MCMonopoly Q ©2012 The McGraw-Hill Companies, All Rights Reserved 38-18 1-18 An Regulated Simple Monopoly MCMonopoly P Pmonopoly Pregulated D MR Qmonopoly Qregulated McGraw-Hill/Irwin Q ©2012 The McGraw-Hill Companies, All Rights Reserved 38-19 1-19 An Regulated Natural Monopoly P Pmonopoly D Pregulated MR Qmonopoly McGraw-Hill/Irwin Qregulated ATC MCMonopoly Q ©2012 The McGraw-Hill Companies, All Rights Reserved 38-20 1-20 ... Gasoline Prices 1998-2008 McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 38-12 1-12 Gasoline Prices and Hurricanes A significant portion of refining capacity in the US is in. .. McGraw-Hill/Irwin Iraq Invasion of Kuwait OPEC massive overproduction OPEC discipline US invasion of Iraq Hurricanes in the Gulf of Mexico Iran-US tensions; Commodity Speculation Global Financial Crisis... significant increase in crude oil prices • 1980’s • Rapid increases in profits led to significant discoveries of oil in Mexico and the North Sea • 1980-1988 Iran-Iraq War • The war led to increased