Nesa identified Issues: Strait of Hormuz
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- 4.2Elasticities
4.1The shockThe supply shock selected by the Department involves complete cessation of shipping through the Strait of Hormuz commencing on 1 March and persisting for one week. Some shipping was assumed to be recommenced in the following week. Specifically, around 25 per cent of normal oil shipments was assumed to pass through the Strait during that week. It was also assumed that the IEA announces collective action in the form of a stock release in the middle of the first week of up to 15 million barrels per day, as necessary. It was assumed that the IEA stock release reaches the market by the end of two weeks from the closure (the end of week 6). Full resumption of shipping is assumed to be realised in the following week (week 7). The supply shock would be preceded by a speculative demand shock – a build-up of precautionary and other speculative buying in the light of the increasing uncertainty that rising political and tension fear of closure would generate. At the conclusion of the incident it was assumed that IEA member countries rebuilt stocks over a 16 week period. In summary, therefore, the event transpires over a 23 week period and commences four weeks before the actual closure. The shock sequence is summarised in Figure .
Source: Department of Resources, Energy and Tourism and ACIL Tasman. The detailed responses to this shock are discussed in the following sections. 4.2ElasticitiesLarge scale disruptions to supply of crude oil or products tend to cause proportionate increases in prices that are much higher than proportionate reductions in supply. Conversely, large supply increases tend to cause price reductions that are proportionately much larger. Shifts in crude oil supply lead to disproportionately large price changes because responsiveness of demand and supply to price movements (price elasticity of demand and supply, respectively) tends to be extremely low (or inelastic) in the short-term. Even in the long-term, this responsiveness tends to be very low compared to most other goods and services. In the economics literature, responsiveness of quantity demanded to price changes is measured by price elasticity of demand, which is defined as the proportionate change in quantity demanded divided by the proportionate change in price (a negative number). Responsiveness of supply to price changes is measured by price elasticity of supply, which is calculated as the proportionate change in quantity supplied divided by the proportionate change in price (a positive number). The importance of very low price elasticities of demand and supply is illustrated by the following. A hypothetical supply shock removing (or adding) Ss per cent of global crude oil production would require a proportionate increase (or reduction) in price of ∆ to clear the market, eliminating a shortage or surplus caused by the supply shock at the price applying before the shock. This market-clearing process would be accomplished by a combination of a proportionate change in quantity demanded of ∆ x Ed and a proportionate change in quantity supplied of ∆ x Es, where Ed and Es represent short-term price elasticity of demand and short-term price elasticity of supply, respectively. The changes in quantity demanded and quantity supplied in response to a market clearing price increase are in opposite directions, but will add to the amount of the initial shock (a price increase reduces quantity demanded and increases quantity supplied, and a price reduction does the opposite, as reflected in the signs of Ed and Es). Therefore, the supply shock, Ss = (∆ x Ed) – (∆ x Es), and the proportionate change in price, ∆ = Ss/(Ed – Es). If the supply shock, Ss = –0.05 (5 per cent reduction in supply) when Ed is –0.05 and Es is 0.05, the proportionate change in price, ∆ = 0.5. So, a 5 per cent reduction in supply leads to a 50 per cent increase in price. Conversely, a supply increase of 5 per cent, with the same values of Ed and Es leads to a reduction in price of 50 per cent. Smith (2009a, p. 155) observed that values of –0.05 and +0.05 for short-term price elasticities of demand and supply for crude oil, respectively were indicative of estimates in the economics literature on the crude oil market. Revising the calculation with the values of Ed and Es suggested by Kilian and Murphy (2010), –0.26 and 0.02, respectively, indicates a 5 per cent reduction in supply would cause a price increase of nearly 18 per cent in the short-term. Using median values of Ed and Es for the last few years of around –0.15 and 0.02, respectively, as estimated by Baumeister and Peersman (2012), a reduction in supply of 5 per cent would cause a price increase of more than 29 per cent in the short-term. Using similar reasoning, a demand shock, Ds = (∆ x Es) – (∆ x Ed), and the proportionate change in price, ∆ = Ds/(Es – Ed). Assuming a positive demand shock of 2 per cent (+0.02), and inserting the values of Ed and Es suggested by Baumeister and Peersman (2012), the resulting price change would be an increase of nearly 12 per cent. A full discussion of recent research and literature on elasticities of demand and supply for crude oil and petroleum products, and interaction of supply shocks and speculative demand shocks is provided in Appendix C. The following sub-sections discuss these influences over the weeks leading up to and during the hypothetical supply disruption.
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