The Falling Price of Energy-Looking Through a Micro Lens
A blog by Frederic Slade, CFA, Assistant Vice President and Senior Director, Investments, Pentegra Retirement Services – February 9, 2016
Much of the recent discussion about the recent plunge in energy prices1 has been focused on the broader, “macro” impacts such as the global decline in stock prices, the excess supply of oil on the world markets and the negative impact of falling oil prices on the growth of emerging markets economies that depend upon energy exports.
It is also important to look at the so-called “micro” impacts that relate to the forces of supply and demand in the energy markets. These impacts give insight into what might occur in the short run as well as longer run in reaction to the recent energy price declines. From a quantitative standpoint, there are two important related economic concepts known as “elasticity of demand” and “elasticity of supply” (you recall these terms from Econ 101). Elasticity of demand is the percentage change in the demand for energy resulting from a 1% change in the price of energy. If consumer demand is inelastic (less than 1), consumers are relatively insensitive to the decline in energy prices, meaning they don’t change their usage very much. This will result in lower revenue for producers. Many studies have found that in the short run, the elasticity of demand for energy ranges between 0.4 and 0.6. That is, demand is inelastic. What about in the longer run? In the longer run, demand is generally more sensitive to price, that is more elastic. In the case of cheaper gasoline, consumers may decide over time to drive more versus using other forms of transportation, such as trains or buses. Alternatively, consumers may stay with oil or gas heat as opposed to other options such as solar. This may eventually benefit those energy companies that can survive in a low price environment over time.
Elasticity of supply is the percentage change in the supply of energy resulting from a 1% change in the price of energy. Like demand, studies have shown in the short run the price elasticity of supply to be less than 1 (i.e. inelastic and relatively insensitive to price). Thus, there may be little initial cutback by energy producers when prices drop because of their fixed costs of production such as drilling and refining. However, over the longer run, elasticity of supply is higher and some producers will go out of business since they won’t be able to cover their operating costs. As a result, there will be less supply on the world markets and energy prices will eventually rise.
In summary, while it is difficult to precisely measure the elasticity of supply and demand now and in the future, the general knowledge that demand and supply are inelastic in the short run and more elastic in the longer run are helpful in explaining the dynamics of consumers and producers in the energy market.
1. The price of WTI Crude futures has declined from $64.57 per barrel in May 2015 to approximately $30.00 per barrel today. Source: Bloomberg.
NOTE: Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Past performance is not a guarantee of future results.
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