Thursday, June 03, 2004

Capacity

Kevin Drum has a post up about the likely future of oil prices. Short version - they're probably going to go up.

The thing about oil production is that any given moment there's some overall production capacity. Once we hit that level of production, then nothing more can be pumped out. Now, over time new reserves can be discovered, new wells dug, and capacity can be increased. I'll leave it to others to determine just how much extra potential capacity exists, but the point I'm trying to make is that even if a lot of it exists it takes some time to find it and bring it online.

So, what does this mean? Well, to answer that let's have a little Econ 101 lesson. The diagram below represents supply and demand in the oil market.



The downward sloping demand curve reflects the fact that as the price of oil falls, the quantity people wish to buy increases. At least in the short term, the demand for oil is thought to be pretty inelastic - that is, pretty insensitive to changes in the price.

The other curve is the supply curve. The horizontal portion of the curve reflects the fact that over some range, oil companies are basically willing to provide as much as customers want at some minimum price. At some point, however, in order to encourage more production the price must rise. The problem is that this upward sloping segment of the supply cuve is fairly "small." That is, it is only over a fairly narrow range of output that price increases actually encourage more production. After that, we run into capacity limit - the vertical range of the curve. Further price increases are not accompanied by any more oil production.

So, what happens if the demand for oil starts increasing? As, say, China and India start increasing their oil consumption. Well, that demand curve starts shifting to the right and the equilibrium price of oil begins to rise. Higher price, but not higher actual consumption. Oil producers happy, as prices will rise above marginal cost. Big profits result.

What happens? Higher prices will, over the longer run, encourage companies to extract oil from areas which may not have been profitable at lower prices. This is the Dick Cheney vision of oil independence -- if the price gets high enough then oil companies will find their oil in more costly domestic locations, and by producing more oil at home we won't rely on foreign oil imports. Then we may get some outward shift of the supply curve, but we'll still be paying higher prices.

So, in a world where the demand curve is probably going to continue to shift outwards, in the short term it's quite possible oil prices could skyrocket. In the longer term, new capacity may be brought online, but as long as demand is increasing faster than capacity...