Chapter 36Energy Prices

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Chapter Outline

• HISTORICAL VIEW• OPEC• WHY PRICES CHANGE SO

FAST• WHAT WILL THE FUTURE

HOLD• ELECTRIC UTILITIES

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You Are Here

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Real Oil and Gas Prices1996 dollars Per gallon (1 barrel=42 gallons)

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Historical Events Relating to Oil and Gas

Prices• 1972 Arab-Israeli War

– US support for Israel prompted an embargo by Arab oil producers against the US and Europe. This led to a significant increase in crude oil prices.

• 1979 Iranian Revolution– Iran’s Islamic revolution led to instability in the Persian

Gulf. This led to a significant increase in crude oil prices.

• 1980’s– Rapid increases in profits led to significant discoveries of

oil in Mexico and the North Sea

• 1980-1988 Iran-Iraq War– The war led to increased production by both parties as

each needed to fund their war effort. This caused a precipitous fall in crude oil prices.

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World Oil Reserves

Group Billions of Barrels in Reserve

Percentage of World Reserves

Persian Gulf 755 58%

Non-Persian Gulf OPEC

168 13%

Rest of the World

387 29%

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OPEC

• The Organization of Petroleum Exporting Countries (OPEC) – Algeria, Indonesia, Iran, Iraq, Kuwait, Libya,

Nigeria, Qatar, Saudi Arabia, United Arab Emirates, and Venezuela

• OPEC began as a cartel. – A cartel is an organization of

individual competitors that join to form as a single monopolist.

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Was OPEC a Cartel?

OPEC production has always been a significant part of the oil market but it has never reached the level of monopoly. The cartel model is still useful because it has been a dominant player.

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The Cartel Model

One Country’s OilMC

ATC

P

QMR

Pcartel

MR’

Qcartel

P

Q

D

S=MC

Market for Oil

QPC

PPCMR

QPCQquota

Profit

Qcheat

Profit

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Why Oil and Gas Prices Change So Fast

• Because expected price is a determinant of supply and demand a world event that causes people to expect a price increase will– Increase current demand (as middlemen and

consumers try to buy as much as possible) – Decrease current supply (as middlemen and

gas stations try to hold onto their current stocks)

• This causes an immediate increase in prices.

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• 1990 Iraq Invasion of Kuwait• 1992-1998 OPEC massive

overproduction• 1999 OPEC discipline• 2003 US invasion of Iraq• 2004-2005 Hurricanes in the Gulf of

Mexico• 2007 Iran-US tensions; Commodity

Speculation• 2008 Global Financial Crisis

Historical Events Relating to Oil and Gas Prices

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From $1 to $4 in Ten Years

1) OPEC production cuts; Low stocks of oil; bad weather2) Release of oil from the Strategic Petroleum Reserve; recession3) Political unrest in oil producing Venezuela and Nigeria; War in Iraq4) Hurricanes Damage Platforms in the Gulf of Mexico5) Threatened Conflict b/w U.S. Iran6) Global Commodity Speculation7) Global Financial Crisis

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Gasoline Prices 1998-2008

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Gasoline Prices and Hurricanes

A significant portion of refining capacity in the US is in the Gulf of Mexico

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Electricity

• Residential electric power tends to be sold by a regulated monopoly.

• It has been a monopoly because of significant barriers to entry.

• It has been regulated because prices would be much higher than is socially optimal.

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Types of Monopolies

• Simple Monopoly: a monopoly in which marginal costs of production are rising.

• Natural Monopoly: a monopoly in which marginal costs of production are falling.

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Monopoly in the Market for Residential Electricity

• The market for residential electricity is likely to be a natural monopoly for nuclear power because of the very high fixed costs (transmission lines and the power plant and diminishing marginal costs.)

• The market may be characterized as a simple monopoly or natural monopoly for coal or gas generated electricity.

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An Unregulated Simple Monopoly

P

Q

MCMonopoly

DMR

Qmonopoly

Pmonopoly

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An Unregulated Natural Monopoly

P

Q

MCMonopoly

D

MR

Qmonopoly

Pmonopoly

ATC

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An Regulated Simple Monopoly

P

Q

MCMonopoly

DMR

Qmonopoly

Pmonopoly

Pregulated

Qregulated

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An Regulated Natural Monopoly

P

Q

MCMonopoly

D

MR

Qmonopoly

Pmonopoly

ATCPregulated

Qregulated

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The California Experience• California produces electricity with natural

gas.• California “deregulated” by

– Having its utilities sell their productive capacity to a variety of competitive producing firms

– Having them buy electricity from these producers– Letting the market price for wholesale electricity float.– Continuing to fix residential electricity prices.

• Natural gas prices increased dramatically• The utilities could not buy the power

because they were selling it at regulated prices that were lower that the deregulated prices at which they were buying it.