South-Western College Publishing - Economics  
The price of oil just keeps going up, up, up...
Subject global supply of, and demand for, oil will continue to increase, but at disparate rates
Topic Elasticity ; Supply and Demand
Key Words

oil, refineries, production, demand, supply, price, consumption

News Story

Global oil demand is expected by grow globally by 2 million barrels a day in 2005, but supply will grow by less than half that rate. A research organization devoted to petroleum issues estimated that this year demand for oil increased by 4.6 million barrels a day, but refinery capacity increased by only 700,000 barrels a day, increasing the bottleneck effect that has kept gasoline and other derivatives scarce relative to demand.

China and India exhibit increasing demand for oil, which will only exacerbate the U.S. problem of an inability to refine enough crude oil to satisfy consumers. U.S. refiners haven't built a new facility since 1976 and the companies continue to find numerous reasons to avoid doing so, from stricter environmental regulations to relatively low returns on such investments.

Other countries are expanding refinery capabilities, but refineries take a long time to build. Saudi Arabia is expanding its refineries, but this capability isn't expected to reduce the shortage until about 2008. The U.S. is trying to offset the difficulties by increasing its gasoline imports from Europe, where the emphasis on diesel automobiles help create a surplus of gasoline.

While this situation is very good for oil refiners--increasing their profit margins on every barrel of oil they sell--the cost increases are profoundly effecting a variety of products, increasing the prices of diesel, gasoline, jet fuel, and home heating oil.

Questions
1.

Indicate with a graph of supply and demand the effect on the price of a barrel of crude oil, given the causes listed in the summary.

2. What assumption is the U.S. refinery industry making about elasticity of oil consumption if these companies hesitate to create new refinery capacity? Explain using economic reasoning.
3. Why would the price of jet fuel (a by-product of the gasoline refining process) increase as the price of gasoline increases? Illustrate your answer with a graph of supply and demand.
Source Bhushan Bahree and Thaddeus Herrick. "Oil Industry's Refining Squeeze Limits Prospects of Price Relief." The Wall Street Journal, 24 May 2005. A1+.

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