Relative Importance of Demand, Supply and Elasticity Factors in the Price of Natural Gas

Question

The global natural gas industry has been plagued by low prices due to massive supplies from mega-projects and low oil prices. However, there may not be enough output to meet growing demand in the longer term due to greater affluence, and more mouths to feed.

Adapted from CNBC News, 17 April 2017

Discuss the relative importance of demand and supply factors and elasticity concepts in determining the price of natural gas. [25]

Answer

The price of natural gas is set at market equilibrium by the interaction of demand and supply, with the direction of any price change decided by which curve shifts and the extent decided by the relevant elasticities. The preamble points to two opposing pressures — currently low prices from abundant supply and cheap oil, against a longer-term tightening as affluence and population grow — so the verdict on relative importance turns decisively on the time period: I argue that supply factors and a low price elasticity of supply, together with the cross-price effect of oil, dominate price formation in the short run, while a demand factor — rising affluence and population against an inelastic long-run supply — dominates in the long run.

Short-run demand factor: low oil prices. Oil and natural gas are close substitutes, both burnt as fuel for energy generation, so their cross elasticity of demand is high and positive ($CED > 1$), as set out in applying XED. Low oil prices therefore draw demand away from natural gas, shifting its demand curve leftward and exerting downward pressure on price. Because $CED$ is large, the fall in demand is more than proportionate, so this is a significant downward force on price — and the more so in the short run, where natural gas supply is price inelastic (extraction and processing take time), so the demand fall translates into a larger price fall.

Short-run supply factor: mega-project output. “Massive supplies from mega-projects” shift the supply curve of natural gas rightward, again pushing price down. The extent depends on the PED of natural gas: since oil is a close substitute, demand is likely price elastic ($|PED| > 1$), so the supply increase produces a less than proportionate fall in price. This blunts the supply effect relative to the demand effect — so, between the two short-run forces, the fall in demand from cheap oil is the more significant in accounting for the currently low price.

Long-run demand factor: affluence and population. Over the longer term, “greater affluence, and more mouths to feed” raise the demand for energy — and hence the derived demand for natural gas as a fuel for transport, heating and electricity — shifting its demand curve rightward and exerting upward pressure on price. The relevant elasticity here is qualified: because demand for natural gas is derived from demand for fuel, a direct appeal to its own income elasticity is less apt than the observation that $YED > 0$ for fuel, so higher income raises gas demand. The exponential character of global population growth makes this a more significant factor in the long run than the short.

Long-run supply factor: tightening supply. That “there may not be enough output to meet growing demand in the longer term” implies the mega-project supply surge will not be sustained and that long-run $PES < 1$, plausibly because natural-gas reserves deplete. With supply inelastic, the long-run demand increase produces a sharp rise in price — so on the supply side the binding long-run fact is not a shift but a low elasticity, which amplifies the demand-driven price rise.

Evaluation and judgement. The relative importance of factors is not fixed but switches with the horizon, and the elasticities are what make the switch legible — they decide whether a given shift moves price a little or a lot. In the short run, the dominant forces are the demand fall from cheap oil (amplified by a high $CED$ and an inelastic short-run supply) and, secondarily, the mega-project supply surge (damped by an elastic $PED$); these account for the currently low price. In the long run, the dominant force is rising demand from affluence and population, amplified by an inelastic long-run supply ($PES < 1$). Two qualifications strengthen rather than overturn this verdict. First, the ceteris paribus assumption may fail: man-made supply shocks such as war can cut supply and spike price sharply enough to swamp the other factors in the short run, and OPEC’s cartel control of oil prices can move the gas price through the substitute channel — so in practice short-run supply-side disturbances may be the single most important determinant. Second, technological change cuts both ways over the long run — alternative-energy development lowers gas demand while better drilling raises supply, both pulling price down — so the long-run upward pressure from affluence is not guaranteed to prevail. On balance, no single factor is the most important across all horizons: supply factors and elasticities (with the oil cross-effect) govern the short-run price, demand factors and an inelastic supply govern the long-run price, and the discipline the question rewards is using the elasticity concepts to weigh extent rather than merely listing shifts.