certain amount of money on a per gallon basis

at the pump, how does that break down who get what?

How much of that goes to the gas station,

verses the transportation network, verses the

refineries, verses the actual oil producers?

The one thing I do want to emphasis is I just

use that as kind of indicative numbers.

They can change widely based on what's going

on in the market, and where we are in the world.

They are fairly indicative. The other thing

I want you to realize is that they aren't

always proportional. It's not like that if oil

prices were to double that this 15 cents that

the retailer got would turn into 30 cents.

In general, regardless of the price of oil,

at least in the United States, the retailer

tends to get between 5 cents per gallon and

20 cents per gallon. It's normally in that

10 to 15 cent range. Some of that has to be

netted against the 5 cents or so that goes

for credit card processing. Taxes can be

relatively fixed. It's often on a per gallon basis.

The spread that the refineries gets, it's

also not necessary proportional to the price

of oil. There are times where the oil prices very

high because their might be a lot of excess

capacities at the refineries.

Their not able to charge a huge premium,

or maybe their not able to get a lot of the

other stuff. The refineries might not be able

to make much if anything on each barrel of oil

that they actual refine. Sometimes it goes

the other way around. A low price of oil,

if the refining capacity is really tight,

the refineries can raise the price of the actual refined

oil products. They can raise more and more money.

The players in this whole supply chain that do,

whose profits are a function of the price of

oil are the oil producers. Just to be clear,

sometimes all of these are owned by the same

company. That's what they call these kind of vertically

integrated oil producers. Sometimes they are

different players, and when they are different

players, the ones that makes the most when oil

prices are high are the producers.

These producers, they invest huge amounts of

money in expiration and then in drilling.

They make some assumptions. They say, "Hey, this

oil rig that I'm going to spend a hundred or

two hundred million dollars on, this is going

to be break even if oil prices are say $30 a barrel."

Obviously, if oil prices end up being at $100 a

barrel, they're going to make a killing.

They're going to make $70 per barrel of profit.

This thing is going to produce millions and

millions of barrels. On the other hand, if oil

prices go down to $15 per barrel, they're going

to be killed. They're going to take a huge loss

on this huge investment they made.

The one question I want to at least attempt to

address, and it's not a simple question.

Many people devote their careers to this.

What is actually dictating the price of oil?

We see it can't be just the traditional supply

and demand, or at least in the short term it can't.

If we look here at 2008. In mid 2008 oil prices

were pushing $150, and then only a few months

later they had collapsed to $32 a barrel.

They had gone down by a factor of 5.

There is something that happened here.

The financial crisis hit, obviously, peoples

expectations of global growth would have been

gone down. The economy wouldn't grow.

People might use a little less energy, a little

less fossil fuels, whatever. That wouldn't

be enough to justify a 5 fold decrease in the

price of oil. Something else is at play.

As you can imagine, a lot of it is just going to be

the psychology of the crowd right over here or the

psychology of market.

People were driving up the price of oil,

and over here people freaked up, and they

started driving down the price of oil.

To think about that in a little bit more concert terms.

I mean think about the price, or I'm going to

think about the oil markets in particular in the long term

and short term, or the long run and the short run.

In the long run, let me draw the long run

right over here. In the long run we can think of

the oil markets like you would think of any

traditional microeconomic market.

Oil is entrusting because it's a microeconomic.

It's one good or service that has huge

implementations on the macroeconomy on the

growth of nations, how they act, and whatever else.

We can think of it in kind of classical

microeconomic terms. That's the price of oil.

That's the quantity of oil. You can imagine

that those first few millions of barrels are

fairly cheap to produce, and then every

incremental millions of barrels.

If you think about this, this is the quantity

the millions of barrels per day.

They have to go explore finding it harder

and harder places, using more and more

technology to find it, so the marginal cost

of producing incremental barrels goes up.

Another way of thinking about this, at a low

price, oil producers say, "Hey, I'm going to

leave that oil in the ground. Why should I pump

it out and produce it now? So there won't be a

lot of quantity produce."

At a higher price they're like hey, we're going

to pump as much as we can. We're going to find

that oil wherever it is. We are going to pump

it and get it to the market.

Two ways to interpret the long run supply curve.

Long run supply.

The demand, also, we can kind of view it in

kind of a classical way. Those first few millions

of gallons, a huge benefit to the consumers.

There are some people that maybe oil is the only

thing they can use. They can't go to any source

of energy. They get huge benefits, but then

the marginal benefit goes down for every

incremental barrel of oil.

Another way of thinking about it, at high prices

there aren't a lot of people who are interested

in doing it. They say,"Thank you. I'll just

go use something else. I'll use solar power,

I'll walk to work, or whatever else."

Then at low prices they say, "Hey. I'm going

to use all the oil I can use. I'm going to drive

my gas guzzler 100 miles to work. I'm just

going to drive it around the block for fun.

I'm going to leave it running, because I don't

like to start my engine, and all the rest."

This kind of gives you a classical model

downwards-sloping demand curve, and an

upward-sloping supply curve. Then you would end up

with some equilibrium price in the long run, and

some equilibrium quantity.

This right over here does not describe this

all too well. Between here and here you did

not have dramatic changes in how people ... the amount of

oil that supplied into the market.

You did not have dramatic changes in peoples

behavior in terms of how they consumed,

or where they consumed a lot or a little of it.

One way to think about it is this is the long run.

Think about dynamics in the long run, if there

is new technology to find new oil to supply

curve could shift to the right like this.

If for whatever reason people start driving

electric cars, then the demand curve could shift

to the left like that. If for whatever reason

it became fashionable again for people to

drive SUVs, the demand curve could shift to the right.

If countries economic growth accelerates, if

people in India and China end up becoming wealthier

and want to buy more combustion automobiles,

it could shift to the right.

In the long term you can think about it in that way.

If there's more drilling, if there's eases

regulation on drilling, you could shift the supply

curve to the right. If you increase environmental

regulations, supply curve could shift to the left.

You could figure out the implications.

That's not what's really at play in the short run.

When I think about the short run, I'm not thinking

about on a second-by-second basis, the short

run is really we're thinking on over a period

of months or even a small number of years.

That's because people aren't changing their behavior

dramatically on a month-to-month basis.

They already bought their cars.

They already bought their gas-guzzling SUVs.

Also, it not easy for suppliers to turn capacity

on or off in the very short run.

In the short run our model might look something

like this. Obviously, these are gross over

simplifications, but they help us think about

it a little bit. This is the quantity.

This is price, so in the short run, the quantity

supplied is really not going to be too sensitive

to price. It might look something like this.

I'll just do it as a vertical line just to really state

how in the short offering, over a of months,

people are just going to pump out the oil that they were

planning on pumping on. Their not going to shut wells.

Their not going not use their tankers or whatever

else to transport their oil.

Their going to produce, and it's going to be

transported to the market.

This is the short run supply curve, regardless

of the price. In the long run, if the prices go

down they might decided to turn off capacity. If prices go

up they might do more expiration, open up more wells,

but that takes time. Often years to do that,

especially if you start from the expiration phase.

This is supply not too sensitive to price.

Demand might look something like this.

Once again this is one way of thinking about it.

A very simple model. Demand might look something ...

I'll do it in orange. Might look something

like this. Where is goes ... looks something

like that. The reason I drew demand that like,

is it kind of fits at least people short term

behavior. If our price right now is right over

here, if it were to pop-up right over there,

in the short run, people don't change their

behavior that dramatically. Their house and

their work is the same distance.

It's takes them a while to start thinking about

moving a little bit closer, changing jobs,

maybe getting a pass for public transportation,

or trading in their gas-guzzling car for another

car, or car pooling, or whatever else.

If prices go down, the other way around.

They might still have their Prius.

They won't trade it in for a more gas-guzzling

car, et cetera, et cetera. What this discribes

is in the short run the prices aren't being

dictated by these classical mircoeconomic inputs

or factors in terms of supply and demand.

What's really effecting them in the short term

is market psychology, and this is why I put a

little picture of Chicago Board of Trade.

Which is where they trade futures contracts.

Futures contracts and I've done video where I

go into detail on what futures contracts are.

They are a way of trading commodities.

Instead of people walking around with vials

or barrels of oil and exchanging them, they say,

"Here's a contract to purchase oil from me in

a month, or at a specific date, or two months

at a specific date." People trade those.