Microeconomics

Can anyone solve the following problem. its a case study format our instructor gave to us. i was able to part one and construct a supply curve. just confused on the remaining parts......


Jerry Dewbre, owner of Dewbre Petroleum, had been very busy over the past 18 months. Dewbre Oil operates 300 wells across the South Texas plains, and with the price of oil going as high as $50 per barrel, the company’s employees were working overtime to take advantage of the resulting profit opportunities. The cash flow generated by higher profits created the further prospect of reopening a group of old oil wells south of San Antonio, Texas that had not been economically viable when the oil price was trading in the $10-30 per barrel range, but all of a sudden appeared to have promise. However, the new oil field development and well-drilling projects available to Dewbre would represent a relatively high cost source of oil, even if things went as well as could be reasonably hoped. Their economic viability would depend on an average price for Texas Light Crude of about $40 per barrel through the 10 year life of the project in question. Calculating the likely future price of oil was critically important to these decisions.

I. The Oil Industry
Crude petroleum comes from decaying vegetation which is trapped underground for many millennia. World petroleum reserves are, therefore, ultimately limited by the geological history of the earth. It is theoretically possible to make synthetic oil from coal (of which massive reserves exist), but this has always been, and promises to remain, prohibitively expensive. Therefore, the prospect of exhausting the available supply of natural crude oil has always been regarded as a potential danger (one of many…) to our energy dependent mode of industrial existence. As early as the late Nineteenth Century, forecasters began to predict the exhaustion of available crude oil reserves in the near future – usually within ten to twenty years. Speculators have just as frequently anticipated an attendant rapid rise in oil prices.

Yet, in practice, crude oil prices (as well as other commodity prices) have largely declined over time, after adjusting for inflation. Between 1870 when the oil industry emerged as a significant economic activity until the early twentieth, crude oil prices fell by 50% in actual dollar terms from about $1.50 to about $0.75 per 42 gallon barrel. Refined petroleum products – fuel oil, gasoline, etc. – declined even more rapidly. These price reductions occurred in the face of rapidly increasing consumption and the effective monopolization of the industry by John D. Rockefeller’s Standard Oil Company. The possibility of natural crude oil reserve exhaustion was outweighed by a steady improvement in extractive and refining technologies which not only lowered prices but lead to a rapid growth in the estimated level of recoverable reserves.
In 1911, the United States government broke the original Standard Oil Company into many competing parts (including Exxon and Mobil, recently merged into today’s ExxonMobil). At the same time, the widespread introduction of the automobile caused the growth of crude oil consumption to accelerate rapidly. Yet between 1910 and the end of World War II in 1945, crude oil prices remained essentially constant in real (i.e., inflation-adjusted terms). And, although the end of the War brought a relatively sharp increase in oil prices per barrel from about $11.50 (in 2004 dollars) in 1945 to about $18 (in 2004 dollars) in 1950 , once the situation stabilized oil prices began a slow, steady decline.
Prices during the early post-war period were determined largely by the actions of seven large oil companies, referred to collectively as the Seven Sisters (Exxon, Mobil, Socal, Gulf, Texaco, Shell and British Petroleum), who consciously attempted to stabilize the oil market in order to stimulate consumption and economic growth. Because of continuing new reserve discoveries and improvements in extraction technology, the ratio of estimated petroleum reserves to world consumption rose throughout this period and prices declined steadily to $17.50 per barrel in 1955, $15.50 per barrel in 1965 and $14 per barrel in 1970.
The foreign countries from which the major oil companies bought oil felt that they suffered from this emphasis on market stability. In 1957, these countries (predominantly in the Middle East) banded together to form the Organization of Petroleum Exporting Countries (OPEC). The member countries – Saudi Arabia, Libya, Qatar, Kuwait, Algeria, Iran, Iraq, United Arab Emirates, Indonesia, Venezuela, Nigeria and Gabon – were initially relatively unsuccessful at raising oil prices. However, following the striking effect of the Arab-Israeli-war-related oil embargo in late 1973, they began to realize the benefits of coordinated output reductions. Crude oil prices rose as a result of this successful collaboration to $63 per barrel in 1981.

Unfortunately for OPEC, this dramatic rise in oil prices stimulated a world wide search for new crude oil sources and induced significant improvements in oil-consuming technologies. Oil from the North Sea, the North Slope of Alaska and a host of off-shore oil-fields displaced OPEC oil sales as OPEC countries had to reduce output to maintain prices. At the same time, rapid improvements in alternate fuel efficiencies, power generation efficiency and overall energy use reduced the growth of world crude oil demand to near zero. In the face of these pressures individual OPEC countries began to exceed their assigned production quotas and per barrel oil prices fell steadily to $41.50 in 1985, $28 in 1990, $18 in 1995 (following a sharp but short-lived increase in 1990 related to the Iraqi invasion of Kuwait), before dropping to $13.50 at the end of 1998. At that point, OPEC’s ability to influence prices appeared to have declined substantially. Oil was produced in significant amounts in more than forty countries by more than thirty major oil producing organizations, and in spite of consolidation through sisterly mergers, the power of the Seven Sisters was very much a thing of the past.
Oil prices started rising again in late 1999, owing to severely depleted inventory stocks of crude oil, possibly triggered by the low prices that prevailed in 1998. Surging demand in China, as well as instability and a big war in the Middle East, pushed prices ever-higher during 2003. Following a brief post-war drop in mid-2003, prices steadily rose, trading in the $40-50 per barrel range through most of 2004 to the present. There was much speculation, however, as to how sustainable these high prices would be.

III. The Oil Market in 2004-5

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