Explain the impacts of cheaper crude oil on the markets for natural gas and refined oil.
Question 1a
Since mid-2014, oil prices have fallen significantly. Technology has lowered crude oil extraction costs and sluggish growth in the global economy has also affected the demand for oil.
a. Explain the impacts of cheaper crude oil on the markets for natural gas and refined oil. [10]
b. Discuss whether demand or supply determinants would be more important in determining whether a fall in the price of crude oil will be persistent. [15]
Essay Breakdown
Factors:
1. cheaper crude oil
Markets Involved:
2. Natural gas, refined oil.
Knowledge of the relationship between natural gas, refined oil and crude oil is required
Concepts required: Demand & Supply: Factors, Single Shift
Introduction
Crude oil is a substitute for natural gas and is an essential factor input required to produce refined oil. Substitutes are goods in which can be considered replacements or alternative choices of each other.
Market for natural gas
Figure 3a: Market for Natural Gas
Crude oil and natural gas are substitutes in consumption (XED>0)
Cross Elasticity of Demand: Measure of responsiveness of the quantity demanded of a good to a change in the price of another good, ceteris paribus.
Lower prices of crude oil -> Consumers would switch from using its substitute natural gas, to crude oil -> Lower demand for natural gas. With reference to figure 3a, which shows the market for natural gas
· Demand curve shifts from DD0 to DD1
· Fall in price from P0 to P1
· Output falls from Q0 to Q1
Market for refined oil
Figure 3b: Market for Refined Oil
Crude oil is a factor input used in the production of refined oil
Lower prices of crude oil -> Lower cost of production of refined oil -> more profitable to produce refined oil at every price level -> increase in supply of refined oil. With reference to figure 3b, which shows the market for refined oil,
· Supply curve shifts from SS0 to SS1
· Fall in price from P0 to P1
· Output increases from Q0 to Q1
Conclusion
We would expect that a fall in both price and output for natural gas. As for refined oil, the increase in supply would have an expected fall in prices and increase in output.
Comments
This question examines your ability to recognise the relationships between crude oil and 2 other goods, and how these relationships would affect the respective markets. This question is also commonly seen in case studies.
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