CASE STUDY QUESTION

The future for oil prices: a case of supply and demand

In its latestCommodity Special Feature(pages 43 to 53 of the October 2020World Economic Outlook), the IMF examines the future of oil and other commodity prices. With the collapse in oil demand during the early stages of the coronavirus pandemic, oil prices plummeted. Brent crude fell from around $60 per barrel in late January to below $20 in April.

However, oil prices then rose somewhat and have typically been between $40 and $45 per barrel since June 2020 - still more than 35% lower than at the beginning of the year (see chart below: clickherefor a PowerPoint). This rise was caused by a slight recovery in demand but largely by supply reductions. These were the result partly of limits agreed by OPEC+ (OPEC, Russia and some other non-OPEC oil producing countries) and partly of reduced drilling in the USA and the closure of many shale oil wells, which the lower prices had made unprofitable.

The IMF considers the future for oil prices and concludes that prices will remain subdued. It forecasts that petroleum spot prices will average $47 per barrel in 2021, up only slightly from the $42 average it predicts for 2020.

On the supply side, it predicts that 'stronger oil production growth in several non-OPEC+ countries, a faster normalization of Libya's oil production, and a breakdown of the OPEC+ agreement' will push up supply and push down prices. Even if the OPEC+ agreement holds, the members are set to ease their production cut by nearly 25% at the start of 2021. This rise in supply will be offset to some extent by possibly 'excessive cuts in oil and gas upstream investments and further bankruptcies in the energy sector'.

On the demand side, the speed of the recovery from the pandemic will be a major determinant. If the second wave is long lasting and deep, with a vaccine available to all still some way off, oil demand could remain subdued for many months. This will be compounded by the accelerating shift to renewable energy and electric vehicles and by government policies to reduce CO₂emissions.

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Questions

1. Describe a scenario in which oil prices rebound significantly over the coming months. Illustrate your answer with a supply and demand diagram. (3 marks)
2. Describe a scenario in which oil prices fall over the coming months. Again, illustrate your answer with a supply and demand diagram. (3 marks)
3. How are the price elasticities of demand and supply relevant to the size of any oil price change? (3 marks)
4. Project forward 10 years and predict whether oil prices will be higher or lower than now. What are the major determinants of supply and demand in your prediction? (3 marks)
5. What are oil futures? What determines oil future prices? (3 marks)

140 120 100 80 $ per barrel 60 MAMA 40 20 0 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Source: Europe Brent Spot Price FOB (Dollars per Barrel), (US Energy Information Administration) Brent spot crude oil prices ($ per barrel, daily)