A look at why oil prices are volatile.
Readers Question: Dear Economics Help. Why is the petrol price so volatile and why when oil price falls don’t the prices of other commodities and services stay the same?
The price of petrol is closely linked to the price of oil. In 2008, the price of oil was very volatile. In the summer of 2008 it reached over $140, but, by the end of the year had fallen very sharply to under $50. With this big fall in the price of oil, it is natural the price of petrol will fall. In fact a good question is why doesn’t the price of petrol fall by a bigger amount?
Part of the reason is that in the UK, petrol prices included a significant tax. The cost of oil only represents about 20-30% of the price of Petrol (that is a guess)
The price of other commodities and services are more likely to move at the annual inflation rate of about 4%. However, oil isn’t the only commodity which is falling in price. Many metals such as copper and aluminium are falling in price due to the global recession.
Why Oil Prices Tend to be Volatile
- People buy and sell oil futures over future expectations. If people expect higher demand in the future, they will buy oil futures, pushing up the price. Similarly, if market sentiment changes, investors will look to sell oil futures before prices. Therefore price changes can have a momentum effect – which is bigger than the underlying economic cause.
- Oil is income elastic. Demand for oil depends on economic growth. If there is a growth in incomes, there will be much greater demand for transport and therefore oil. Therefore, the demand for oil is highly cyclical. The sharp fall in the price of oil in 2009, is a result of the global recession of 2009. The rise in prices in 2010, was on the prospect of a return to global economic growth.
- Supply is inelastic in the short term. If there is a sudden rise in demand, it takes time for producers to increase supply. It is not always possible to supply more because it depends on how much oil is in the ground. In theory, OPEC can intervene and alter supply to target certain prices, but in practice it is difficult.