The law of supply and demand primarily affects the oil industry by determining the price of the "black gold." Expectations about the price of oil are the major determining factors in how companies in the industry allocate their resources. Prices create incentives that influence behavior. This behavior eventually feeds back into supply and demand to determine the price of oil.

Key Takeaways

  • The most striking feature of the oil market is the low price elasticity of demand.
  • The supply of oil is also fairly inelastic.
  • Oil price swings tend to be dramatic and often impact the rest of the economy.

The Low Elasticity of Demand

The most striking feature of the oil market is the low price elasticity of demand. That means demand for oil is not very responsive to changes in prices. It is easy to see this by looking at your own life. If you have a car, you usually continue driving to work, going to stores, and visiting friends regardless of the price of gasoline. Your demand for oil does not change very much based on the price, and it works the same way for others.

Even people who use less oil have a relatively inelastic demand for it. Someone who uses mass transit or lives close to work will not move out to the suburbs and buy a gas-guzzling SUV just because the oil price fell. At most, lower oil prices will induce people to take more vacations in the short run. Oil prices have a strong impact on airline fares and the cost of driving across the country.

In the long run, businesses and consumers can adapt to changing oil prices. Companies might react somewhat more quickly to improve the energy efficiency of their operations. Consumers have to be at the right point in their lives to make changes. When someone is ready to buy a new car, fuel efficiency becomes more important when oil prices are high.

The low price elasticity of demand for oil is quite different from the demand for other goods and services, even other types of energy. For example, higher natural gas prices can lead to more use of solar, coal, and oil for generating electricity. However, most automobiles in 2020 still required gasoline, and therefore oil, to function.

The Low Elasticity of Supply

As a general rule, supply is less responsive to price changes than demand. However, the supply of oil is fairly inelastic, even by the standards of supply curves.

First, it helps to consider why supply is generally less elastic than demand, particularly in the short run. There is a fixed supply of goods at any given moment, and demand must adapt. For instance, the sudden increase in people working from home during the coronavirus crisis created a shortage of consumer paper products at stores in 2020. People previously got toilet paper, facial tissues, and paper towels from different companies via their employers while at work. In the short term, consumers simply had to reduce their demand.

The supply of oil is even less elastic than most other goods because of the specialized investments that are often needed to extract oil. Much of the equipment that is used to mine gold or silver can be diverted to mining platinum or palladium as prices shift. However, expensive equipment used for hydraulic fracturing and offshore drilling often cannot be used for anything else. As a result, oil companies may take years to develop oil fields when prices are high. Furthermore, they often have to continue producing oil even when prices fall because the equipment has no other uses.

Boom and Bust

Since both supply and demand for oil are not very responsive to price changes, oil price swings tend to be dramatic. Furthermore, oil price changes often impact the rest of the economy.

Sudden disruptions in the oil supply can cause recessions, while a decline in the oil price can fuel an economic boom.

Most people in developed countries need oil to go to work, school, or even to the store to get food. We don't want to give up on any of that and are willing to pay more, but everyone else is in the same boat. As a result, oil prices have to go up a lot to get consumers to change their behavior. Oil firms also need to take in those big profits to fund the development of more oil fields, which is very costly and high risk.

High oil prices mean a boom for the oil industry and often a bust for other industries. Everyone who uses a traditional automobile suddenly has to pay more for gas, so they have less disposable income available for other goods. The impact of higher gas prices is often higher for people who have lower incomes.

On the other hand, low oil prices usually mean a bust for oil firms and a boom for other industries. The oil companies find their costly investments in fracking and offshore oil wells becoming unprofitable. Other businesses suddenly see their energy expenses fall and their profits rise. Lower transportation costs tend to benefit trade and boost commerce. Finally, consumers see their disposable incomes rise as fuel costs fall.

Real-Life Examples

An example of the impact of high oil prices occurred around 2011. At that time, the cost of crude soared above $100. Massive investments poured into the sector via credit and new companies. Production increased in response to high prices, especially with innovations in hydraulic fracturing and oil sands. These investments could only be justified based on high oil prices and eventually contributed to an oil glut in 2014.

But the high cost of oil also led to great improvements in efficiency, which decreased demand for energy on a per-person basis. There was also deflationary pressure due to tighter monetary policy in the United States. Given the supply and demand dynamics, oil prices plummeted in 2014.