Multiple equilibrium and the drastic fall in oil prices
Posted November 21, 2008on:
The world price of oil has now declined to under $50US a barrel, a third of it’s peak value (live prices here).
This takes me back to a post we did at the end of May – when fuel costs were pushing up at a rate of knots. The topic was covered in the name: Collusion, multiple equilibrium, and petrol prices.
Now the fundamental argument was that, as petrol prices increase, net exporters face an increase in aggregate income and so want to save/invest more. Leaving oil in the ground is a form of investment. As a result, producing countries may reduce extraction in the face of higher prices (specifically if this has increase future expectations of prices). If all oil producers start doing this, then it pushes petrol prices up further and so on and so on. This implies two things:
- a small increase in demand may lead to a massive increase in prices,
- Even if demand is unchanged a small shock to prices may “push” us into a higher price “equilibrium”.
Now we also said that if this concept (which has been championed by Paul Krugman) had any power, a small decrease in international demand should lead to a collapse in prices and an INCREASE in fuel production (that cannot be explained by new oil fields coming online – also note that the increase is a sufficient condition, as long as production is higher than it would have been solely from a shift in the demand curve then this result would hold, and this could conceivably be at a lower level than prior to the shift in demand).
We’ve seen the price fall come to pass – but I have no data on the quantity yet. That will be very interesting to see.