crude-oil-mcx

The Economics of Crude Oil

Why has the price of crude oil been in free-fall mode recently?  Why does the world catch a cold when the price of crude oil sneezes?  Why are different countries having opposite but equally intense reactions to the recent crude oil price level change?

If these are questions that you have been pondering lately, hopefully you’ll have some answers by the end of this post.

Farid is extremely rich – the source of his wealth is the smurl he extracts in his backyard. Smurl is a fundamentally essential product for two reasons: (1) multiple essential products can be extracted from it; (2) these smurl products provide the basic ingredients for the energy that drives most of the manufacturing, mechanical, and electrical processes in the entire world!  Smurl is the result of natural activities in the ground, and like similar naturally-produced items like gem stones, the locations where it can be found is independent of human manipulation, making it a precious resource. This is why Farid is rich – everyone needs at least one of smurl‘s outputs in their every day activities, and his backyard is one of the few places in the world where it can be extracted.  What further works in Farid’s favour is that the cost of extracting smurl is low.

There are a handful of other individuals like Farid who have since discovered smurl in their backyards and have earned quite a bit of money from the sale of the extracted product, with more money in their future as there still remains smurl in decent quantities below their houses.  Farid and some of these other people, realising how important their smurl is to the world, came together and decided to form the Smurl Cartel (“SC”).  Among SC’s objectives is to manipulate their production levels to influence the price of smurl in the global market: when they think it is getting too cheap, the reduce the amount they produce to create a scarcity situation, which eventually causes the price to rise.

Thomas also has smurl in his backyard.  Thomas has a very large family that consumes a very large quantity of the various smurl outputs on a daily basis.  Thomas has not been able to extract enough smurl to meet the needs of his family, so he needs to buy from Farid and the rest of his friends in the SC to make up the shortfall.  Thomas is not happy about this as his pockets are subject to the whims of the SC.  In fact, he is very cautious about being the cause of Farid’s unhappiness in whatever form, as that could result in him and his family not being able to cook their meals or heat their home as a result of Farid limiting his access to smurl.

Over the last ten years, a number of SC members have experienced various levels of family drama that thoroughly impacted their respective abilities to extract and sell their smurl.  This resulted in a rather limited quantity of this product available for the world to buy and use for an extended period of time.  At the same time, some families’ economic activities grew considerably, increasing their need for smurl products.  Consequently, the price of smurl went to an all-time high, almost 1.5x the highest price it had been before this period.  Everyone else felt the pinch in their pockets, except for Farid and his SC friends who were extremely happy with the development and their bulging pockets.

Due to his disadvantaged position, Thomas has been on a quest to figure out a way to become independent of the SC cartel for his basic energy needs.  He got some members of his family to focus on achieving this goal: Some of them investigated alternative sources like the sun and nuclear power.  Others investigated how to obtain smurl from non-traditional sources.  After painstaking research, one of the groups stumbled on an amazing discovery – the rocks in their compound contained some properties which, with the right equipment and process, could yield a liquid with properties very very similar to smurl!  They named it rock smurl, and set about testing and fine-tuning the necessary equipment and processes to extract and refine to the smurl outputs.  Shortly after, Thomas was able to produce enough rock smurl, which when combined with the smurl he produced, to cater for almost all his family’s energy requirements. Finally!  He no longer had to rely on smurl from Farid and his SC friends!  In fact, he could potentially extract more than his family can consume and become a seller like them :-). Sweet!

Thomas’ excitement was not shared by the SC.  Not only had one of their biggest buyers disappeared from the buying side of the market, some of the individuals with family drama had since resolved some of their issues to the point that allowed them to resume their former smurl extraction levels.  All of a sudden, there was too much smurl in the market!  There were still a lot of families that did not have any smurl in their backyards and still needed to buy, but not enough to fill the gap Thomas created.  The over-supply of smurl in the market caused the price to dive south, losing 50% of its value in less than 6 months.  At the next SC meeting, unlike their usual move when smurl price is not moving in their favour, Farid and his friends decided not to reduce the amount of smurl they were supplying the market.  They decided to leave the market to decide who will survive.  Their reasoning is that Thomas’ family spends a lot more to produce their rock smurl, and if the smurl price drops too low, Thomas will be extracting the rock smurl at a loss as rock smurl and smurl are priced the same.  Therefore, the price of smurl can only fall so low, and may in fact eventually rise again.

While the SC waits to see whether their bet will pay off,  the members are adjusting their respective purses just in case it does not.  Some members did a better job of “making hay while the sun shone,” while others did not do so well.  Those who did are breathing easy, while those who did not are in panic mode.

In the story above, our respective real life players are:

Farid = Saudi Arabia

smurl = crude oil

Smurl Cartel (SC) = Organization of the Petroleum Exporting Countries (OPEC)

Thomas = United States of America

rock smurl = shale oil

Still got questions?  Please ask in the comment box below, or send an email to comments@finomics101.com – look forward to hearing from you!

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6 thoughts on “The Economics of Crude Oil

  1. zadebowale

    2 points. We need to work together.Your brand of financial education is lacking in our schools. When is your review on the cause and effect of the rising dollar rates coming out? Oh that was 3 points!

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    1. Bash B Post author

      He he – no penalty here for exceeding points :-).
      (1) Yes, we should; (2) thanks – would be great if financial education is included from the early years’ curriculum; (3) working on it!

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      Reply
  2. Ameze

    Excellent break down of the economics of crude oil pricing. With it being simplified like this, even primary school students would understand this.

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    Reply
  3. Pingback: Much Ado About FX (Part I of III) | Finomics 101

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