A well documented and notated Wikipedia article on price elasticity of demand defines it as "a measure of responsiveness of the quantity of a good or service demanded to changes in its price." The article provides the formula below, which I applied to some projections of the effect of sanctions on Iranian oil exports. The math tells us that the effect would be seemingly small from the simple drop in production, though the psychological effect upon the market, which cannot be calculated through a formula, could be much larger.
The formula for the coefficient of price elasticity of demand as provided by Wikipedia:
Price Elasticity of Demand equation by Wikipedia - Creative Commons Attribution-ShareAlike License
The coefficient is nearly always a negative number. This is common sense, since when prices rise, demand usually falls. The article then goes on to provide the PED's of some standard commodities, including oil, which it puts at -0.4, on a worldwide basis.
High school math should tell us that if you know the PED and the percent change in quantity, then you can calculate the percent change in price by multiplying the PED times the percent change in quantity. So let's do the math!
We do have an idea as to how much a reduction in quantity that sanctions, set to take effect by the end of June against Iran's oil shipments, is being targeted by the west: 40%. This figure appears in a Congressional Research Service report dated February 10. The report states:
"This confluence of policies has already begun to reduce Iran's oil sales and might reduce them by as much as 40% (1 million barrels per day reduction out of 2.5 million barrels per day of sales). Iran is widely assessed as unable to economically sustain that level of lost oil sales."
We can therefore look at the total exports of Gulf crude, calculate the overall decrease, make an allowance for some increased production from other states, and arrive at a figure for the price of Gulf crude, upon full application of the sanctions.
The U.S. Energy Information Administration in its latest tables stated that the Persian Gulf states produced 23,714 thousand barrels per day of crude as of October 2011, which we'll round to 23.7 million.
At the current time, Saudi Arabia is already producing more than usual to make up for the drop in Libya oil production. Let us arbitrarily state, then, that the other Gulf states will make up no more than 20% of the shortfall in Iranian production; thus, the calculation would be as follows:
- 23.7 million, total Gulf production
- minus .8 million (loss of 1 million Iran, plus .2 additional additional from Saudi Arabia and/or others)
- equals 22.9 million as the new production level.
- .8 divided by 23.7 equals a percentage drop of 3 and 1/3 percent. (-0.033)
Taking our PED formula and the Wikipedia coefficient for world oil, then:
-.4 times -.033 = +1.33 percent change in the price of Persian crude, based upon the drop in supply.
The January 2012 price of Dubai crude (the benchmark for the region) is $110. Adding 1 1/3% puts the new price at $113.63.
I'm neither a mathematician nor an expert in oil pricing, and so would love to hear from anyone who has experience in the subject regarding this excercise. I know enough to know that my calculations could be laughably off the mark.
Finally, while I'm sure that market pyschology would have a bigger negative effect than these numbers, these numbers could serve as a "ballpark" for expectations. I am firmly of the belief, and agree with the Congressional Research Service when it states that a 40% drop would severely impact the government or Iran. That makes it likely that the situation would escalate into violence, and the $113.63 price would probably look like a bargain once that happened. Imagine if the Straits of Hormuz were to close -- that would be about 17 million barrels, and price speculation would drive prices further through the roof.
This article originally appeared at scribillare.com.