If Libya’s Oil is Shut Down, Oil Could Hit $142/bbl

Muammar Gaddafi

Using the short run price elasticity of demand, it is possible to calculate the impact of the secession of Libyan oil production on world oil prices.  There are a number of estimates of the short run price elasticity of demand for crude oil from a number of leading journals.  They range from -0.034 to -0.05 to -0.077.  Based on this range, -0.05 should be a good enough estimate for the purposes of this post.  As I stated in my video two weeks ago, there are reasons to believe that the short-run elasticities of both supply and demand are far more inelastic than most economists believe, but for simplicities sake, -0.05 is an adequate estimate.  Assuming the adjustment to the supply and demand curves will come entirely from the demand side, we can use the following equation to estimate the change in price:  Short Run Elasticity of Demand = % change in quantity supplied / % change in price.  I believe this is a fair assumption, given the fact that recent Wikileaks releases, which I discuss in another post, have shown us that the available spare production capacity of Saudi Arabia may be grossly overstated, resulting in a far smaller cushion of spare oil capacity available to reduce the effect of a shock like this.  Any price improvement from slack taken up by spare production capacity may be lost in the trading frenzy that would follow an event like this.

The actual Brent crude price today was $108 / bbl – an increase of $8 since last week, when the Libyan collapse started.  This means that the increase in the oil price as a percent of the $42 increase potential is 8 / 42 = 0.19047619.  So the $8 increase in oil price since the Libyan collapse began is signaling that the market believes that there’s about a 20% chance that Libya will halt all oil production.

If the price of oil gets much higher, we will be running dangerously close to the point where demand destruction will cause the world economy to sink back into a recession.  This paper uses the short run oil price elasticity of GDP to find that for every 1% increase in the price of oil, the US economy looses .05% of its GDP.  To put it another way, with a $14.5 Trillion economy and with oil at $100/bbl, for every $1 increase in the price of oil, our economy looses $7.3 Billion of GDP.  With today’s $5 oil price increase, the United States lost $36 Billion in GDP.  If Libya’s crude oil production is taken offline, and the oil price spikes to $142/bbl, the US economy would loose $335 Billion in GDP – a 2.3% decline that would push the US economy back into a recession.