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Why Oil Prices Can’t Bounce Very High; Expect Deflation Instead

Why Oil Prices Can’t Bounce Very High; Expect Deflation Instead

Economists have given us a model of how prices and quantities of goods are supposed to interact.

Figure 1. From Wikipedia: The price P of a product is determined by a balance between production at each price (supply S) and the desires of those with purchasing power at each price (demand D). The diagram shows a positive shift in demand from D1 to D2, resulting in an increase in price (P) and quantity sold (Q) of the product.

Unfortunately, this model is woefully inadequate. It sort of works, until it doesn’t. If there is too little a product, higher prices and substitution are supposed to fix the problem. If there is too much, prices are supposed to fall, causing the higher-priced producers to drop out of the system.

This model doesn’t work with oil. If prices drop, as they have done since mid-2014, businesses don’t drop out. They often try to pump more. The plan is to try to make up for inadequate prices by increasing the volume of extraction. Of course, this doesn’t fix the problem. The hidden assumption is, of course, that eventually oil prices will again rise. When this happens, the expectation is that oil businesses will be able to make adequate profits. It is hoped that the system can again continue as in the past, perhaps at a lower volume of oil extraction, but with higher oil prices.

I doubt that this is what really will happen. Let me explain some of the issues involved.

[1] The economy is really a much more interlinked system than Figure 1 makes it appear.

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