With some crude oil prices spiking last week jumping to their highest level in two years or more on news of possible intervention in Syria by the United States and its allies, Americans might well echo British Prime Minister Neville Chamberlain’s plaintive query about why people should worry about “a quarrel in a far-away country between people of whom we know nothing.”
Syria produces little oil, our country imports little from the actual Mideast, and overall U.S. oil imports are dropping as a result of new drilling and fracking technologies.
So why should we pay more to fill our gas tanks just because fighting surges in Syria?
The answer is that even though West Texas Intermediate, or WTI, crude oil is not exactly the same as Brent or Dubai-Oman oil, these are substitutes at some margin. And the market for crude oil is a global one, even if the range of physical and chemical characteristics of crude oil is wide. Furthermore, oil can be transported long distances at relatively low cost. So even if it is Syria that is catching the cold, Minnesota drivers may end up sneezing a lot.
All this is prompted by a reader asking why U.S. prices, as indicated by the price of WTI at Cushing, Okla., should rise just because some European or Middle East grade of crude is rising.
The underlying question arises early in any micro-econ course in which students learn about supply and demand. That leads to the question of “shifters,” or factors other than a product’s own price, that lead producers or consumers to change the quantities they are, respectively, willing to produce and sell or to buy.
An important shifter in supply-and-demand relationships is “the price of related goods” that either can be “substitutes” or “complements.”
For example, if the price of ground beef goes up, people will buy more chicken, even if the price of chicken doesn’t change. If the price of soybeans goes up, farmers will produce less corn, even if the corn price does not change. That is because these goods are substitutes in consumption or in production, respectively, and it is the price of one good relative to the other that is important.
Some substitutes are “perfect” or nearly so. Most people cannot tell if their granulated sugar comes from cane or beets. But although consumers will shift from hamburger to chicken in response to price changes, the price has little impact on lamb or lobster.
Sometimes, linkages are multi-step. An increase in the price of soybeans will reduce wheat production, even if much of the wheat is grown in areas too dry for beans and most beans are grown in counties where wheat has not been harvested for a century.
There are however, some places where wheat acres can shift directly to soy, such as northwest Minnesota or central Kansas.
Moreover, an increase in soy prices will draw some acres from corn, which is a close substitute in production since it needs the same climate and soil and uses the same planting and harvesting equipment.
If the price of corn thus goes up, so does that of barley, which is a very close substitute for corn in feeding livestock. And barley growing competes directly with wheat in areas too arid to grow soybeans. Similarly, the increase in soy prices will raise the prices of canola and sunflowers, also sources of vegetable oil. And both of these are alternatives to wheat in areas too dry or with too short a growing season for soy.
So even though wheat, a raw material for bread, is quite different from soy, an oilseed, in the needs it meets, the two are “related goods” in several ways.
There are similar complex relationships in crude and refined petroleum markets. U.S. refineries get little, if any, crude from the pipeline terminals in Syria that load oil from further east. But if a French refinery that sources oil there gets cut off by war, it may buy several tankerloads of North Sea oil. Some refineries in New England also may get oil from such wells off Norway or Scotland. So they will have to pay more than they would have had to for the same oil. Or they may instead choose to get more oil via rail from North Dakota or by pipeline from Oklahoma or via tanker from the Gulf Coast.
Greater demand for North Dakota oil from New England will mean that less of it will flow south to the hub for WTI in Oklahoma, thus pushing up the price of this U.S. reference grade just as greater demand via pipeline or tanker would.
Other European refineries whose supplies are cut off by military operations in the eastern Mediterranean may obtain oil from Venezuela or Mexico that might otherwise have been available to the U.S.
Moreover, an increasing fraction of U.S. refined gasoline is now exported, with sales in many different countries. Areas in which supplies of either crude or refined petroleum get cut off by fighting in Syria may be forced to make up the slack with gasoline from U.S. sources.
Both the supply of petroleum and the demand for its products are highly inelastic, at least in the short term. That means the quantities produced and sold or purchased and consumed don’t vary greatly with price.
When this is true, very small shifts in either the quantities supplied or demanded can prompt very large swings in prices. Small changes “at the margin” have a much bigger effect than people might think.