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Supply and demand is a live issue for the oil industry

IS Adam Smith dead? Now thats an interesting question, and one which Slugcatcher thinks a few peo...

The Slug reckons dear old Adam, along with his theories of supply and demand, is alive and kicking.

For readers of the more ignorant kind, engineers and the like who never studied the arts or economics, Adam Smith was the Scottish chap who published a book in 1776 titled “The Wealth of Nations”.

It was Adam who suggested that there was “an invisible hand” at work in the market which helped supply and demand oscillate around a point called equilibrium – that is where supply and demand are in balance.

Since this is not a revision course in Economics 101, The Slug will cut quickly to the chase by asking whether we really understand the demand side of what’s happening in today’s oil market.

Supply, we all understand. Production is static, peak oil is the hot topic, big new oilfields are not being found, the end is nigh etc etc etc…

But demand is something that we all seem to be forgetting. And we shouldn’t, because what Adam proposed in 1776 is as valid now as it was then.

As price rises, demand falls – subject to another force in economics called elasticity, which is simply how far demand can stretch before it breaks.

With oil, because it is such a fundamental building block of most societies, the elasticity factor is substantial. In other words, Joe Bloggs the builder must have a tank of gas for his van or he can’t go to work.

But – and this is the real question – what is an oil price of $US60 a barrel really doing to demand over the long haul.

A short, sharp, dose of pain inflicted by the $US60 price is manageable for most businesses. But if prolonged, it will create havoc and change the way in which some economies work. It will slow production, force factories to close and, eventually, lead to reduced demand.

Oil at $US60 will force Joe Bloggs to find another way to get to work. It will also force governments to change tax laws to encourage alternative energy sources, and force big industries that consume a lot of liquid fuel to switch, or die.

Whichever way you slice the oil cake, a sustained high price will cut demand.

It is the inevitability of this demand cut which The Slug poses as this week’s deep thought, and while the drop in demand might not occur until the world itself is plunged into a recession, it will happen.

The only question is when.

And The Slug thinks he’s seen the first signs of real pain in the consuming world as a steady stream of big companies that use lots of liquid fuel report falling profits, and the initiation of cost-cutting measures.

Perhaps, over time, the question of raising supply will not be such as big issue because the flipside of the equation, demand, will have provided the answer as the oil market seeks out Adam Smith’s view of perfection – equilibrium.

For investors, right now could be a time to watch demand as closely as supply because as the market moves back to a point where supply equals demand (and possibly exceed it) there is a real chance that the oil price will contract.

How long this will take is anybody’s guess. The Slug’s suggestion is a few years, though the early signs of demand contraction or, at least, a slowdown in growth, are there for all to see.

Long live Adam Smith!

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