Where Are Oil Prices Going

In 2015, the price of oil collapsed from $ 80/barrel down to $ 27 in February 2016 as Saudi Arabia decided to expand production to retake market share and no longer reduce production to maintain high prices, since then the price has rebounded to above $ 40 as the glut cleared. An interesting question for the future of oil prices can OPEC act as monopoly as it has as demand expanded and prices increased or has the market move closer to a model of perfect competition due to several factors:

(a) As the global economy moves to a slower trajectory, growth in global oil demand is declining requiring OPEC to decide on production cuts. For OPEC to act as a monopoly in sharing the pain is questionable.

(b) Since Iran sanctions have been lifted in 2015 allowing Iran to export oil, competition with Saudi Arabia, the defector leader, may also undermine OPEC acting as a monopoly.

(c) Oil consumers are less dependent on oil from the Middle East as oil is produced domestically in particular in the US due to a new technology fracking compromising OPEC s control of supply.

(d) Carbon emission causing city pollution and climate change has been a force in the public funding of research and development of electric vehicles to replace gasoline motors, a major source of pollution. Electric vehicles (Tesla Motors) are starting to compete with gasoline vehicles in the top of the automobile range as such it will be only a matter of time that electric vehicles will be an attractive alternative in the mass market and publicly preferred source. Gasoline demand made from oil will at one point in the future collapse but that looks like being later than 2030.

When more than one producer country as in the case of OPEC supply the global market for oil, the question can be asked: will they cooperate to share Q forming a monopoly or compete and produce more than their quota? The answer depends on demand dynamic and probable competitive strategies employed by each country although we can assume that a perfect monopoly is not likely given competition between countries.

The demand dynamic followed a relatively stable trajectory moving in lock step with growth of the global economy prior to the credit crisis of 2008 as such investment in maintaining an increasing oil supply as a function of demand was relatively consistently tight. Nash Game Theory informs us that each producing country responds to the production of the other in order to maximize its profits reaching a Cournot competitive equilibrium at a price in a range between MR = MC (marginal revenu is equal to marginal cost) and the monopoly price Pm shown above.

A sudden contraction of the global economy in 2008 left producer countries with excess product and storage. The previously tight match between supply and demand widened, storage incresed and countries had no other option but to compete on price (Bertrand Competition) pushing the price down to the marginal cost, MC. In the short term MC =0 because the infrastructure to produce is in place.

Global oil demand did recover after 2008 but has remained less predictable as such the market has oscillated between a Cournot Oligopoly for OPEC ( producing countries have some control of production) and a Bertrand competition (producing countries bid down prices to the marginal cost because of an oversupply of product). Prices collapsed in 2015 and bottomed at about $ 27 in February 2016.

We can now frame a response to the global oil market changes flagged in the introduction:

(a) Slowing Global Growth and Demand for Oil

As consequence of slowing demand, investment in finding and developing new reserves has been sharply curtailed as such reducing the maximum supply 80 Million Barrels/Day in this example before marginal cost starts in increase rapidly. A Cournot competitive oligopoly should apply even if oil demand contracts although sudden states of oversupply are likely causing sudden Bertrand price competitions driving prices down to marginal cost for short periods.

(b) Lifting of Iran Sanctions

The addition of Iran as a global supplier will dilute the Cournot competitive oligopoly but not change it fundamentally.

(c) New Shale Oil Technology

Investment in shale oil technology in the US and elsewhere compromising OPEC did occur after 2008 although the collapse of oil prices in 2015 reduced interest in shale oil as an alternative source to big producers.

(d) Electric Substitution in Transportation

Electric automobiles looks increasingly likely to replace gasoline motorized automobiles in the next half century at least in the developed countries although the tipping point for oil production is difficult to appreciate. The Financial Times suggests one in four vehicles will be electric by 2040. Oil is likely to remain a critical source of energy for at least 25 years. Unless investment in oil production increases significantly, it is unlikely that oil prices will remain below $ 50/barrel for long.