News is still moving very quickly regarding the global impact of conflict in Ukraine. The inevitable impact to energy markets is still coming into focus, but some common misconceptions about supply and demand implications of oil are worth discussing now.
Russia is said to represent approximately 10 percent of world daily oil production, which after domestic use means they export somewhere in the mid-single-digits of net world oil exports. For our purposes we will call it 5 percent. If we suddenly removed 5 percent of daily oil production from the world market, what impact would that have on oil prices? The answer is not straightforward; to figure it out we have to consider what economists call elasticity of demand.
A perfectly elastic good would mean that demand is infinite at one price and zero at a slightly higher price. An example would be a store selling one-dollar bills. Priced at $1, the store would just be a complicated ATM. Price them at 99 cents and I’d borrow money to buy as many as possible. Price them at $1.01 and I wouldn’t buy a single one. That’s a perfectly elastic good.
On the other end of the spectrum would be a perfectly inelastic good. The most common example is a lifesaving medicine. If 100 people a year need it and 100 doses are produced each year, the price might be $100. If only 99 doses were produced, the price wouldn’t rise to $101 — in fact, there’s no theoretical maximum price. Hopefully there would be a fair way to allocate this medicine, but someone is going to be very disappointed no matter what. They don’t call economics “the dismal science” for nothing!
Oil demand is relatively inelastic. If oil production representing 5 percent of daily demand suddenly went away, prices would start rising and continue to rise until we felt enough pain to reduce worldwide oil consumption by 5 percent — that could be at $5/gallon of gas, $10/gallon, or more. There’s no way of knowing for sure.
Is there any way around this? Regulations or voluntary measures to cap oil prices sound great, but just like rent controls in NYC, price control comes with a cost. At a lower price, demand would greatly exceed supply, so any sort of meaningful oil price controls would have to be combined with extreme shortages or extremely unpleasant rationing. Consumption would have to fall somehow — the world can’t consume more oil than is produced forever (though production would certainly ramp up elsewhere over time).
The fact that the U.S. produces a lot of oil so we don’t “need” Russian oil and don’t import much today doesn’t mean prices necessarily stay low in America. If oil was $25/barrel in the U.S. and $200/barrel in Europe, Europeans would buy U.S. oil and ship it to Europe as fast as they could sail tankers, eventually finding a new equilibrium price somewhere between the two. Could we put some sort of export control in place to prevent this? Possibly, but the ripple effects from such a move would likely be extremely chaotic, ineffective, and even counterproductive.
There are powerful forces pushing prices higher aside from simple corporate greed. Oil companies aren’t blameless, but oil markets are more complicated than they might seem on the surface. If you’re convinced the oil companies are getting away with something here, why not put everything you have in oil stocks? That’s obviously not a good idea — returns on oil stocks are likely not going to feel like a windfall from here when prices inevitably come back down. In the end, even oil company executives would agree that a peaceful end to hostilities in Ukraine and a normalization of prices, trade, and economic activity is the best outcome for all, an outcome we all hope can be realized very soon.
Gene Gard CFA, CFP®, CFT-I™ is Chief Investment Officer at Telarray, a Memphis-based wealth management firm that helps families navigate investment, tax, estate, and retirement decisions. Ask him your question at ggard@telarrayadvisors.com or sign up for the next free online seminar on the Events tab at telarrayadvisors.com.
