© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Chapter 33 Energy Prices

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Chapter Outline HISTORICAL VIEW OPEC WHY PRICES CHANGE SO FAST WHAT WILL THE FUTURE HOLD ELECTRIC UTILITIES

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Real Oil and Gas Prices 1996 dollars Per gallon (1 barrel=42 gallons)

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Historical Events Relating to Oil and Gas Prices 1972 Arab-Israeli War –US support for Israel prompted an embargo by Arab oil producers against the US and Europe. This led to a significant increase in crude oil prices Iranian Revolution –Iran’s Islamic revolution led to instability in the Persian Gulf. This led to a significant increase in crude oil prices. 1980’s –Rapid increases in profits led to significant discoveries of oil in Mexico and the North Sea Iran-Iraq War –The war led to increased production by both parties as each needed to fund their war effort. This caused a precipitous fall in crude oil prices.

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin World Oil Reserves GroupBillions of Barrels in Reserve Percentage of World Reserves Persian Gulf71061% Non-Persian Gulf OPEC 15713% Rest of the World 30426%

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin OPEC The Organization of Petroleum Exporting Countries (OPEC) –Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, and Venezuela OPEC began as a cartel. –A cartel is an organization of individual competitors that join to form as a single monopolist.

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Was OPEC a Cartel? OPEC production has always been a significant part of the oil market but it has never reached the level of monopoly. The cartel model is still useful because it has been a dominant player.

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin The Cartel Model One Country’s Oil MC ATC P Q MR P cartel MR’ Q cartel P Q D S=MC Market for Oil Q PC P PC MR Q PC Q quota Profit Q cheat Profit

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Why Oil and Gas Prices Change So Fast Because expected price is a determinant of supply and demand a world event that causes people to expect a price increase will –Increase current demand (as middlemen and consumers try to buy as much as possible) –Decrease current supply (as middlemen and gas stations try to hold onto their current stocks) This causes an immediate increase in prices.

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 1990 Iraq Invasion of Kuwait OPEC massive overproduction 1999OPEC discipline 2003US invasion of Iraq Hurricanes in the Gulf of Mexico Historical Events Relating to Oil and Gas Prices (cont.)

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin From $1 to $3 in Six Years 1)OPEC production cuts; Low stocks of oil; bad weather 2)Release of oil from the Strategic Petroleum Reserve; recession 3)Political unrest in oil producing Venezuela and Nigeria; War in Iraq 4)Hurricanes Damage Platforms in the Gulf of Mexico

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Gasoline Prices

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Gasoline Prices and Hurricanes A significant portion of refining capacity in the US is in the Gulf of Mexico

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Electricity Residential electric power tends to be sold by a regulated monopoly. It has been a monopoly because of significant barriers to entry. It has been regulated because prices would be much higher than is socially optimal.

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Types of Monopolies Simple Monopoly: a monopoly in which marginal costs of production are rising. Natural Monopoly: a monopoly in which marginal costs of production are falling.

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Monopoly in the Market for Residential Electricity The market for residential electricity is likely to be a natural monopoly for nuclear power because of the very high fixed costs (transmission lines and the power plant and diminishing marginal costs.) The market may be characterized as a simple monopoly or natural monopoly for coal or gas generated electricity.

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin An Unregulated Simple Monopoly P Q MC Monopoly D MR Q monopoly P monopoly

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin An Unregulated Natural Monopoly P Q MC Monopoly D MR Q monopoly P monopoly ATC

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin An Regulated Simple Monopoly P Q MC Monopoly D MR Q monopoly P monopoly P regulated Q regulated

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin An Regulated Natural Monopoly P Q MC Monopoly D MR Q monopoly P monopoly ATCP regulated Q regulated

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin The California Experience California produces electricity with natural gas. California “deregulated” by –Having its utilities sell their productive capacity to a variety of competitive producing firms –Having them buy electricity from these producers –Letting the market price for wholesale electricity float. –Continuing to fix residential electricity prices. Natural gas prices increased dramatically The utilities could not buy the power because they were selling it at regulated prices that were lower that the deregulated prices at which they were buying it.