Wednesday, September 28, 2016

The Marginal Oil Producer Happens to be in Kansas

The Planet Money team recently set out to see who sets the price of oil. They found out that it was not some financial speculator or an arab sheik. Instead, the price is set by the cost of production at the most expensive well still operating.
So here is what sets the price of oil. You take all the oil people are buying today. Start at the end of the spectrum, where oil is cheapest to produce, and work your way up until you've satisfied all that demand. That last barrel you need, the most expensive one someone is willing to buy, that's the one that sets the global price for oil. If you're looking for someone who is setting the price, you look for someone who is just about to turn an oil well off or on.

In their case, they had bought oil from a Kansas pastor named Jason Bruns who had just decided to shut down a well on his property.

1 comment:

  1. According to Froeb when calculating pricing, fixed costs are irrelevant because they do not vary with how much oil is produced. Since average costs contain fixed costs using them to analyze extent decisions could lead to mistakes. Therefore what should be considered are the marginal revenue and marginal costs of each barrel of oil. Dan Murphy’s research confirms this notion. The relevant costs of a barrel of oil should be based on the marginal costs for the price of the last barrel of oil needed to be able to supply the total demand of oil for that given time period.

    From the article, Dan Murphy stated ”Start at the end of the spectrum, where oil is cheapest to produce, and work your way up until you've satisfied all that demand.” This aligns with the idea of using extent decisions for analysis as he was computing the costs and benefits of taking each additional step to get the barrel of oil supplied. When trying to meet the demand, suppliers started at the lowest cost oil producer and kept adding vendors to meet the need of the demand. Each vendor had increased costs to produce the barrel of oil. The number of steps and marginal costs keeps increasing until the supply of oil was met.

    So long as the marginal benefits are greater than the marginal costs, keep taking additional steps until supplier demand is satisfied. At this point, marginal revenue should equal marginal cost which is where the price for the barrel of oil should be maximized.