How could a 2% increase in world oil production lead to a 70% fall in the price?

┬áLet’s start with a hypothetical situation. Suppose a part of the world population has to take a certain pill in order to function. Without it, they cannot do anything except sit and stare at the wall. This group numbers 60 million people out of a nation of 140 million people. Now suppose that a group of companies banded together to control the majority of the pill production. This arrangement has been in place for as long as most people can remember. This group is called the “Organization of Pill Exporting Companies” or OPEC for short.

Pill Market Dynamics

The pill is 100% VITAL for the lives of 60 million people. For the rest of the population, it is a nice treat, in that it tastes like a jelly bean or a tic tac, and even gives you a nice boost, like the effect of a nice ‘energy shot’ Convenient, but not essential. For years, OPEC either could not or would not produce more than 61.5 million pills per week. This is the market with the 60 million ‘mandatory ‘ pills and an extra 1.5 million pills for the rich and famous to pop ‘just because it’s cool’ and for businessmen and law students to gain an intellectual advantage. Thus, the market was stable, and prices were high because there was sufficient mandatory demand and a small discretionary demand. OPEC charged a hefty price for the pill, and most of the member companies got rich. Then, a new company found a way to make the pill and was not a part of OPEC. They started making only 1.23 million pills per week (a 2% increase in supply). They were funded by VC and didn’t have to turn a profit for 4 years, because their investors were dumb, and the founders of this company were good salesmen, telling them that the market was HUGE and the profits would be HUGE because they always were in the past.

Pill Price Fallout

Now, this company goes to sell the pill. Who will buy it? Although the pills sold for $100 per pill, no further people in the nation needed the pill, and it was produced for between $5-$65 a pill depending on the company producing it. The price fell drastically, to $30. Some people were happy that their pills were cheaper, others lost their jobs at OPEC companies. The pill industry downsized, anand d a large fight brewed within OPEC. Within a couple of years, the $65 producers went bankrupt and quit producing. OPEC fell apart as a group of companies, and some were merged and others were bought out.

Citizens grew accustomed to the pill being between $25-$35. Major media always would come out with reports stating that the pill would go through a major shortage shortly and that prices would get back to the $100 level or even shoot through to the $200 level in the next year, but it would never happen. Investors would pour money into the pill companies, only to get bored after a year, and sell out to chase some other fad.

Pill Market Dynamics: A Lesson in Marginal Demand

Still other companies found a way for the pill to last longer for those who ab, absolutely needed it, so demand dropped to only 50 million pills a week. The nation survived, and the citizens were reasonably happy. OPEC was consigned to being mentioned in only a single paragraph on page 149 of the history textbooks for 4th graders. That is how a tiny change in production can have an astounding impact on prices. It all depends on how the marginal demand is. If the marginal demand was willing to pay $65 a pill, that is what it would cost. In the pill market (and the current oil market) marginal demand is what sets the price. Not the bulk of demand.

Now, the oil market is much more complicated than the pill market that I described above, but the concept is still the same.

By ukpia