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  • In the last video we explored when you pay a

  • certain amount of money on a per gallon basis

  • at the pump, how does that break down who get what?

  • How much of that goes to the gas station,

  • verses the transportation network, verses the

  • refineries, verses the actual oil producers?

  • The one thing I do want to emphasis is I just

  • use that as kind of indicative numbers.

  • They can change widely based on what's going

  • on in the market, and where we are in the world.

  • They are fairly indicative. The other thing

  • I want you to realize is that they aren't

  • always proportional. It's not like that if oil

  • prices were to double that this 15 cents that

  • the retailer got would turn into 30 cents.

  • In general, regardless of the price of oil,

  • at least in the United States, the retailer

  • tends to get between 5 cents per gallon and

  • 20 cents per gallon. It's normally in that

  • 10 to 15 cent range. Some of that has to be

  • netted against the 5 cents or so that goes

  • for credit card processing. Taxes can be

  • relatively fixed. It's often on a per gallon basis.

  • The spread that the refineries gets, it's

  • also not necessary proportional to the price

  • of oil. There are times where the oil prices very

  • high because their might be a lot of excess

  • capacities at the refineries.

  • Their not able to charge a huge premium,

  • or maybe their not able to get a lot of the

  • other stuff. The refineries might not be able

  • to make much if anything on each barrel of oil

  • that they actual refine. Sometimes it goes

  • the other way around. A low price of oil,

  • if the refining capacity is really tight,

  • the refineries can raise the price of the actual refined

  • oil products. They can raise more and more money.

  • The players in this whole supply chain that do,

  • whose profits are a function of the price of

  • oil are the oil producers. Just to be clear,

  • sometimes all of these are owned by the same

  • company. That's what they call these kind of vertically

  • integrated oil producers. Sometimes they are

  • different players, and when they are different

  • players, the ones that makes the most when oil

  • prices are high are the producers.

  • These producers, they invest huge amounts of

  • money in expiration and then in drilling.

  • They make some assumptions. They say, "Hey, this

  • oil rig that I'm going to spend a hundred or

  • two hundred million dollars on, this is going

  • to be break even if oil prices are say $30 a barrel."

  • Obviously, if oil prices end up being at $100 a

  • barrel, they're going to make a killing.

  • They're going to make $70 per barrel of profit.

  • This thing is going to produce millions and

  • millions of barrels. On the other hand, if oil

  • prices go down to $15 per barrel, they're going

  • to be killed. They're going to take a huge loss

  • on this huge investment they made.

  • The one question I want to at least attempt to

  • address, and it's not a simple question.

  • Many people devote their careers to this.

  • What is actually dictating the price of oil?

  • We see it can't be just the traditional supply

  • and demand, or at least in the short term it can't.

  • If we look here at 2008. In mid 2008 oil prices

  • were pushing $150, and then only a few months

  • later they had collapsed to $32 a barrel.

  • They had gone down by a factor of 5.

  • There is something that happened here.

  • The financial crisis hit, obviously, peoples

  • expectations of global growth would have been

  • gone down. The economy wouldn't grow.

  • People might use a little less energy, a little

  • less fossil fuels, whatever. That wouldn't

  • be enough to justify a 5 fold decrease in the

  • price of oil. Something else is at play.

  • As you can imagine, a lot of it is just going to be

  • the psychology of the crowd right over here or the

  • psychology of market.

  • People were driving up the price of oil,

  • and over here people freaked up, and they

  • started driving down the price of oil.

  • To think about that in a little bit more concert terms.

  • I mean think about the price, or I'm going to

  • think about the oil markets in particular in the long term

  • and short term, or the long run and the short run.

  • In the long run, let me draw the long run

  • right over here. In the long run we can think of

  • the oil markets like you would think of any

  • traditional microeconomic market.

  • Oil is entrusting because it's a microeconomic.

  • It's one good or service that has huge

  • implementations on the macroeconomy on the

  • growth of nations, how they act, and whatever else.

  • We can think of it in kind of classical

  • microeconomic terms. That's the price of oil.

  • That's the quantity of oil. You can imagine

  • that those first few millions of barrels are

  • fairly cheap to produce, and then every

  • incremental millions of barrels.

  • If you think about this, this is the quantity

  • the millions of barrels per day.

  • They have to go explore finding it harder

  • and harder places, using more and more

  • technology to find it, so the marginal cost

  • of producing incremental barrels goes up.

  • Another way of thinking about this, at a low

  • price, oil producers say, "Hey, I'm going to

  • leave that oil in the ground. Why should I pump

  • it out and produce it now? So there won't be a

  • lot of quantity produce."

  • At a higher price they're like hey, we're going

  • to pump as much as we can. We're going to find

  • that oil wherever it is. We are going to pump

  • it and get it to the market.

  • Two ways to interpret the long run supply curve.

  • Long run supply.

  • The demand, also, we can kind of view it in

  • kind of a classical way. Those first few millions

  • of gallons, a huge benefit to the consumers.

  • There are some people that maybe oil is the only

  • thing they can use. They can't go to any source

  • of energy. They get huge benefits, but then

  • the marginal benefit goes down for every

  • incremental barrel of oil.

  • Another way of thinking about it, at high prices

  • there aren't a lot of people who are interested

  • in doing it. They say,"Thank you. I'll just

  • go use something else. I'll use solar power,

  • I'll walk to work, or whatever else."

  • Then at low prices they say, "Hey. I'm going

  • to use all the oil I can use. I'm going to drive

  • my gas guzzler 100 miles to work. I'm just

  • going to drive it around the block for fun.

  • I'm going to leave it running, because I don't

  • like to start my engine, and all the rest."

  • This kind of gives you a classical model

  • downwards-sloping demand curve, and an

  • upward-sloping supply curve. Then you would end up

  • with some equilibrium price in the long run, and

  • some equilibrium quantity.

  • This right over here does not describe this

  • all too well. Between here and here you did

  • not have dramatic changes in how people ... the amount of

  • oil that supplied into the market.

  • You did not have dramatic changes in peoples

  • behavior in terms of how they consumed,

  • or where they consumed a lot or a little of it.

  • One way to think about it is this is the long run.

  • Think about dynamics in the long run, if there

  • is new technology to find new oil to supply

  • curve could shift to the right like this.

  • If for whatever reason people start driving

  • electric cars, then the demand curve could shift

  • to the left like that. If for whatever reason

  • it became fashionable again for people to

  • drive SUVs, the demand curve could shift to the right.

  • If countries economic growth accelerates, if

  • people in India and China end up becoming wealthier

  • and want to buy more combustion automobiles,

  • it could shift to the right.

  • In the long term you can think about it in that way.

  • If there's more drilling, if there's eases

  • regulation on drilling, you could shift the supply

  • curve to the right. If you increase environmental

  • regulations, supply curve could shift to the left.

  • You could figure out the implications.

  • That's not what's really at play in the short run.

  • When I think about the short run, I'm not thinking

  • about on a second-by-second basis, the short

  • run is really we're thinking on over a period

  • of months or even a small number of years.

  • That's because people aren't changing their behavior

  • dramatically on a month-to-month basis.

  • They already bought their cars.

  • They already bought their gas-guzzling SUVs.

  • Also, it not easy for suppliers to turn capacity

  • on or off in the very short run.

  • In the short run our model might look something

  • like this. Obviously, these are gross over

  • simplifications, but they help us think about

  • it a little bit. This is the quantity.

  • This is price, so in the short run, the quantity

  • supplied is really not going to be too sensitive

  • to price. It might look something like this.

  • I'll just do it as a vertical line just to really state

  • how in the short offering, over a of months,

  • people are just going to pump out the oil that they were

  • planning on pumping on. Their not going to shut wells.

  • Their not going not use their tankers or whatever

  • else to transport their oil.

  • Their going to produce, and it's going to be

  • transported to the market.

  • This is the short run supply curve, regardless

  • of the price. In the long run, if the prices go

  • down they might decided to turn off capacity. If prices go

  • up they might do more expiration, open up more wells,

  • but that takes time. Often years to do that,

  • especially if you start from the expiration phase.

  • This is supply not too sensitive to price.

  • Demand might look something like this.

  • Once again this is one way of thinking about it.

  • A very simple model. Demand might look something ...

  • I'll do it in orange. Might look something

  • like this. Where is goes ... looks something

  • like that. The reason I drew demand that like,

  • is it kind of fits at least people short term

  • behavior. If our price right now is right over

  • here, if it were to pop-up right over there,

  • in the short run, people don't change their

  • behavior that dramatically. Their house and

  • their work is the same distance.

  • It's takes them a while to start thinking about

  • moving a little bit closer, changing jobs,

  • maybe getting a pass for public transportation,

  • or trading in their gas-guzzling car for another

  • car, or car pooling, or whatever else.

  • If prices go down, the other way around.

  • They might still have their Prius.

  • They won't trade it in for a more gas-guzzling

  • car, et cetera, et cetera. What this discribes

  • is in the short run the prices aren't being

  • dictated by these classical mircoeconomic inputs

  • or factors in terms of supply and demand.

  • What's really effecting them in the short term

  • is market psychology, and this is why I put a

  • little picture of Chicago Board of Trade.

  • Which is where they trade futures contracts.

  • Futures contracts and I've done video where I

  • go into detail on what futures contracts are.

  • They are a way of trading commodities.

  • Instead of people walking around with vials

  • or barrels of oil and exchanging them, they say,

  • "Here's a contract to purchase oil from me in

  • a month, or at a specific date, or two months

  • at a specific date." People trade those.

  • In the near term, what's really driving the price

  • of oil? What's really causing these fluctuations

  • right over here? That can't really be described

  • by all of these things, is peoples psychology, and

  • peoples information. They look at things like

  • the Middle East. They say, "Will Israel,

  • Benjamin Netanyahu, Israels Prime Minister,

  • decide to preemptively bomb Iran in an attempt

  • to get rid of their nuclear program. Will Iran

  • do something crazy? How would they retaliate?

  • Would they try to close off the straight of our moves?"

  • Even if no one really believes that is happening,

  • some of them might say, Well someone else

  • might believe it." They might buy the futures contracts