EC5005 Petroleum Economics and Project Evaluation

&
BU5053 Introduction to Energy Economics

Lecturer:
Dr. Sola Kasim
Economics, Business School
 Lecture 1

1. Course organisation
2. The theories of demand and supply
 Outlines
Course organisation
• Required skills set
• Aims
• Timetable
• Tutorials
• Assessments

• Theories of demand and supply

 Course organisation - 1
Required skills set
• No prior economics or finance
• Calculations & Diagrams -a little Maths + “Economic Intuition”

Aims
• Introduce key concepts in economics and finance.
• Investment decision making in energy industries.
• Economic analysis key issues energy markets and policies.
(See the Course Syllabus for more)

Classes
Lectures
• Monday 2 - 4pm
• Wednesday 10am – 12noon
(BU5053)
• Friday 11am – 1pm
(EC5005)
 Course organisation – 2
Tutorials
• Thursdays 10am - 1pm
• One hour each group. Should know your group/time allocation
• Starts Thursday 31st October
• Go through exercise sheets handed out in previous week

Assessment
• 80% Exam - Mock Exam handed out
• 20% Course Assessment
• In-class test on Monday 11th November
(no “re-take” option)
• Example Coursework Assessment will be handed out
 Course organisation – 3

The Common Grading Scale (CGS)

• The alphabetical assessment scale with equivalent numerical marks:
Excellent Very good Good Pass Marginal Fail Fail Fail
A1 22 B1 17 C1 14 D1 11 E1 8 F1 5 G1 2
A2 21 B2 16 C2 13 D2 10 E2 7 F2 4 G2 1
A3 20 B3 15 C3 12 D3 9 E3 6 F3 3 G3 0
A4 19
A5 18

• All assessments are marked in terms of an alphabetical CGS, which is the way
you will see it in your student portal. However, for practical reasons we will
often refer to the equivalent numerical CGS marks.

• For more on CGS, see the Common Grading Scale (CGS) descriptor at
MyAberdeen.
 Course organisation - 4
• Main Learning Outcomes
• Students should be able to:
• Understand key economic elements of energy markets and how the
economic environment structures the way in which businesses make
decisions.
• Understand how economic models attempt to capture key features of reality
in the petroleum and energy markets.
• Understand the construction and analysis of an economic model and in
particular how the model solutions may depend on assumptions.
• Demonstrate knowledge and understanding of basic financial concepts such
as: Present Value, the opportunity cost of capital, real options and their role
in business decision-making.
• Critically evaluate Government interventions in the petroleum and energy
markets, using economic and finance tools.
 Course organisation - 5
• How do you learn – effectively?
• The overarching goal of the learning outcomes outlined above is to “transform”
students into near-enough subject experts. This goal would be realised through
effective teaching and learning. It takes two – the lecturer and student.

• Learning is a means to an end – the end being the intended learning outcomes. As
such, effective learning is one that substantially or totally accomplishes the
expected end.
•
• Much depends on how the learner engages with the task (BU5053 and EC5005, in
this case) being learned.
• Several writers including Ramsden (1992) and Meyer and Land (2005) have
identified approaches to learning. According to Ramsden, each approach consists
of two associated attitudinal “what” and organisational “how”, respectively
constituting the approach’s necessary and sufficient conditions for success. The
attitudinal “what” refers to what attitude or motivational belief a learner brings to
the table, while the organisational “how” refers to the way and manner the learner
structures the information gathered about the task.
 Course organisation - 6
• How do you learn – effectively?
• Deep-holistic approach: The deep approach is when the student
demonstrates a positive attitude or motivational beliefs towards the task
being learned by making a deliberate and conscious effort to understand
it, through understanding the connections between the evidence or
reasoning and any conclusion drawn from them.

• However, wilful intention to understand alone will not deliver effective

learning. It must be accompanied by an optimal structuring of the task’s
information set, as manifested in the learner demonstrating a capacity to
holistically integrate the parts into the whole set.

• “Deep approaches are related to higher quality outcomes and better

grades.” Ramsden (1992)
 Course organisation - 7
• How do you learn? How do you learn effectively?
• Surface-atomistic: In this approach the student’s attitude is less positive,
having wilfully decided not to understand the whole learning task
(BU5053/EC5005) but only the parts considered useful to passing an
assessment test or completing the course requirement.

• Usually, the “relevant” parts of the course are memorised or rote-learned.

• Organisationally, surface learning is associated with atomistic information

structuring, in which little is done to integrate the parts into the whole.
• “Surface approaches are dissatisfying; and they are associated with poorer
outcomes”. Ramsden (1992).

• So, how do you want to learn BU5053/EC5005? Deep or surface?

• The Course Team encourages you to set your mind from the start on learning
by the deep-holistic approach.
 Course organisation - 8
•Student Course Evaluation Form
(SCEF)/Course Feedback Form?
•Until last semester SCEF was the cornerstone
of the University’s mechanisms for seeking
feedback from students. It has now been
replaced by the Course Feedback Form (CFF),
to essentially serve the same purpose.

•You will be expected to complete a formal

CFF towards the end of the Course.

•The Course Team urges you strongly to

participate in the survey.
Course organisation - 9
Expectations

• Read textbook references before the class.

• Clarifying questions in lectures welcome.
• Lectures provide guide and focus only.
• Lecture Notes ≠ Lecture ≠ All material required
• You should not expect immediate understanding on all issues.
• However, the Course Team expects you to work independently to
identify areas and questions which you do not understand, arising
from lectures, exercise sheets etc.
The Course Team
• Prof. Alex Kemp – (for part of EC5005)
• Paulina Kajda – Course Secretary (BU5053 & EC5005)
• Dr. Sola Kasim – Course Co-Ordinator (BU5053 & EC5005)
Theory of Demand: How do consumers decide what to buy?

Definition of Demand:
The quantity demanded (Qd) of a good or service is the
amount a consumer is willing to buy at a given price and
point in time.

Key Assumptions:
• Individuals have preferences over goods & services
• Given choice can express preference
• ‘Satisfaction’ from the consumption of a good/service falls as
more of good is consumed – Law of diminishing marginal
utility.

Willingness to Pay (WTP) – maximum amount an individual is

willing to sacrifice to consume one unit of a good.
WTP reflects the “Opportunity Cost” of how much is given
up – depends personal valuations.

Law of Demand
The higher the price the lower the quantity demanded, all other
things remaining equal (ceteris paribus).

A demand curve showing the

negative relationship between
the price and quantity
demanded of a good/service.
Individual Level Example
Houseowner 5 rooms. Likes to have all rooms warm during day.
Controls radiator each room – on/off switch only.
Cold Weather. Heating each room “costly”
One Unit of Heat Consumed/Day (e.g.10 kWh) each room if
Radiator on

Economic Theory
Houseowner has preferences
Can express these preferences
Some rooms seen as most preferred to heat, e.g. Living room.

WTP declines as consumption of good increases

Researcher arrives, asks order of preference and Willingness to Pay to
heat each Room

Room Preference WTP £ per

day
Living Room 1 3
Kitchen 2 2
Toilet 3 1
Bedroom 1 4 0.75
Bedroom 2 5 0.25

Also defines Quantity WTP £ per

Willingness to Pay Heat (Units) day
Function for Quantity 1 3
Heat 2 2
3 1
4 0.75
5 0.25
 Homeowners WTP for Heating
3.5

2.5

1.5

0.5

0
1 2 3 4 5 6

Quantity
Quantity, i.e. heating
Number units consumed
heating
consumed

Economic Theory
All Individuals have WTP Functions
 WTP Information very useful
What is the value of 2 units of heating to Homeowner ?

Blue Area

Quantity Heating
Consumed
 WTP Curve defined Individual’s Demand function
Say Price Heating Each Room £1.50 per day/£0.7 per day?

How many Units of Heat would Homeowner buy?

Quantity WTP £ Price £
Heat per day Per unit
(Units)
1 3 1.5
£1.5
2 2 1.5
3 1 1.5
£0.7
4 0.75 1.5
5 0.25 1.5

Law of Demand Quantity

The higher the price the lower the quantity demanded, all other Heating
things remaining equal. Consumed

Note Quantity demanded – point on WTP/Demand Curve.

Demand = Demand Curve/Schedule
Economic Theory
Individuals have Preferences over all possible goods and
services.

Implication
WTP /Demand functions for all types of goods and services

For example, Heat, Electricity, Petrol, Food, Luxury Goods,

Insurance, Banking Services, Environmental Services, Clean Air,
Existence of Species e.g. Elephants........

Key Element - Economics has nothing to say about what

“should” be valued or,
Fhow it “should” be valued by final consumers

Individual Preferences and therefore WTP/Demand Schedules

may be very different.
Other Determinants of Individual Demand
• Demand curves are two-dimensional – own price and quantity:
𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 = 𝑄𝑄𝑑𝑑 = f 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

• In the real world, other factors apart from the good’s own price affect its
demand. These are held constant while analysing the effect of own
price on the quantity demanded.
• However, if the other factors change - induces Change in Demand
Curve

Main Other Influencing Factors

Prices of Related Goods
• Substitute – used in place of good Complement- used
in conjunction with the good in question
Income
Tastes & Preferences
Impact – Shifts Demand Curve Inward or Outward (Left or Right)
Example: Unexpected increase in income.
Householder WTP to pay for heating in each room increases by £2.

D1
5

Increase demand
D0
at given price

£1.5

Quantity
Qd0 Qd1 Heating
Consumed
 Market Level – Sum of Individual Demand Curves

. . . . . . . . .
. . . . . . . . .
. . . . . . . . .

Price
Large number of individuals in the Market – Approximate
smooth Market Demand Curve
Actual Shape – Empirical Matter. Linear usually
assumed for analytical convenience Does it
Always Touch Axes?

Quantity
..
Shifts vs. movements along a demand curve - 1

1. A movement – caused by variation in the explicit determinant (price)

Price

B
P1
A
Market P0
Price A price-change-induced movement
along a demand curve

Quantity
Qd1 Qd0

Embeds Law of Demand

.. Shifts vs. movements along a demand curve - 2

2. A (rotational) shift example – caused by a variation in the

underlying/exogenous factors. (Price of good constant)
Price
A rotational shift (based on the same axis) of the
demand curve from D0 to D1 induced by a fall in the
price of a rival/substitute good.

Market P0
Price

Do
D1
Quantity
Qd1 Qd0
Is the Demand Curve
movement parallel shift of
rotation? Empirical
Question
.. Shifts vs. movements along a demand curve - 3

3. A parallel shift example

Price
A parallel shift of the demand curve from D0 to D1 (an
increase) induced by an increase in income.

Market P0
Price
D1

Do

Quantity
Qd0 Qd1
Supply and the Price Mechanism

• The Price Mechanism refers to the way and manner market prices are
determined through the interaction of demand and supply forces.
• Market prices – play a key role in Economics, coordinating production
(supply) and consumption (demand) decisions
• Having briefly considered demand, attention now turns to supply.

Abstract Model of Production Decisions - Supply

Firms –use factors of production (land, labour, capital) to produce goods

and services

Decide Quantity supplied Qs of Good/Service (How much?)

Assume Firms choose Qs to Maximize Profits

Law of Supply - The higher the price, the higher the Quantity supplied
(Qs), all other things remaining equal (ceteris paribus).
Stylized Example Oil Producer owns 5 oil wells.
Each well produces 1m barrels/day if operated (“On or Off”).
Production Cost/day varies
Well A B C D E
Cost/day 10 60 45 30 20
$m

Maximize Profits –Use cheapest well first

Production 1 2 3 4 5
M b/day
Extra Well A E D C B
Marginal 10 20 30 45 60
Cost/day $m
Total Cost 10 30 60 105 165
/day $m
 Marginal Cost – the extra cost of producing an extra unit of output

Price/cost

Production 1 2 3 4 5
M b/day
Total Cost 10 30 60 105 165
/day $m
Extra Well A E D C B
Marginal 10 20 30 45 60
Cost/day $m

Quantity (m barrels)
 Firm’s Supply Curve

Price
/cost

Quantity (m barrels)
Price
/cost

Quantity (m barrels)
 Shifts in the supply curve - 1

Example: A shift induced by the Government’s imposition of a

$20/bbl. per well Production Tax

Production 1 2 3 4 5
Mb/day
Well A E D C B
Costs/bbl. ($m)
Pre-tax 10 20 30 45 60
New 30 40 50 65 80
 Shifts in the supply curve - 2

Diagrammatic illustration

S1

S0

$35

S1 = new supply curve

S0 = original supply
curve
Supply falls to 1m barrels/day
Other Determinants of Quantity Supplied At Firm Level
Not just taxes are important

Other Main Exogenous Factors

Technology
Prices of Factors of Production
Prices of Related Goods produced

If other factors change induces

Change in Supply Function

Shifts Supply Curve Inward or Outward (Right or Left)

Market Supply - Sum of Individual Firm Supply

Example Industry - Two Firms

Production 1 2 3 4 5
Mb/day
Firm 1 10 20 30 45 60
Cost

Firm 2 15 25 35 50 65
Cost

What is overall production in market if price is $40?

Market Level – Sum of Individual Firms’ Supply Curves (2-firm)
Firm 1 Firm 2

$40

$35

Market Supply
 Market Level – Interpretation
Profit/Producer Surplus/Rent - Producing Q* at price P*

P*

Q*
Total Cost – Producing Q*
Market Level – Sum of Individual Firms' Supply Curves (several firms)

. . . . . . . . .
. . . . . . . . .
. . . . . . . . .

Large number of firms in Industry – Approximate Smooth Market Supply

Curve

Price
S0

Quantity
 Actual Shape?
As in the demand analysis, the actual shape of the supply curve is an empirical
question. For convenience a linear function consistent with the Law of Supply is often
used.
Profit/Producer Surplus/Rent - Producing Q* at price P*
Price
S0

Market P*
Price

Total Cost – Producing Q*

Quantity
Quantity
Supplied Qs*

Interpretation Given Price – Supply Curve determines Quantity

Supplied in Market
Other Determinants of Market Supply
(Not just Price and taxes considered thus far)

If other factors change induces

Change/Movement in Supply Function

Main Factors
Technology
Prices of Factors of Production
Prices of Related Goods produced
The Number of Suppliers

Shifts Supply Curve Inward or Outward (Right or Left)

 Example: Effect of technological improvement
Given Price Supply Curve determine Quantity Supplied

Increase supply at given price – Outward

Price shift
S0
.

S1
Market P*
Price

Quantity
Qs 0 Qs 1

Technology
e.g. New Invention reduces costs
. Example: Effect of an increase in factor costs
Given Price Supply Curve determine Quantity Supplied

Price
S1
S0

Market P*
Price
e.g. increase in wages

Decrease supply at given price inward shift

Quantity
Qs 1 Qs 0
Price determination

The law of supply and demand:

The price of any good adjusts to equilibrate the quantity
demanded and supplied.

The initial equilibrium

• At the equilibrium price

P1 quantity, the quantity
demanded Q1 is the
same as the quantity
supplied Q1.
• At equilibrium, neither the
consumer nor the
producer desires a
change.
• An equilibrium can be
stable or unstable.
The out-of-equilibrium experience

A perturbation strong enough to cause a shift in either or both of the supply

or demand curves will create a disequilibrium.

• Stable equilibrium – when the market participants re-adjust relatively well

and quickly to establish a new equilibrium.

• Unstable equilibrium – when the market takes a much longer time, if

ever, to re-establish an equilibrium.

• The speed of adjustment is important.

3 steps to analysing changes in equilibrium

1. Establish the source of the “noise” and its immediate incidence -
whether or not it firstly shifts the demand or supply curve, or both.
2. Establish whether the curve shifts to the right or left and, by how much.
3. Use the demand and supply diagram to compare the initial and new
equilibria which show how the noise/shift affects the equilibrium price
and quantity.
The oil supply shock

The various events that may affect the domestic and/or international oil
markets (contextualisation, important) – causing shifts in the commodity’s
supply and demand curves - are broadly classified as:
• a. Above ground – or, generally man-made
• e.g. rapid economic growth, unexpected severe weather conditions,
new taxes etc.
• b. Below-ground or, geological – e.g. maturity of a hydrocarbon province.

An increase in demand (e.g.

caused by economic growth)

• Any event that increases the

quantity demanded at a
given price will cause an
outward shift from D1 to D2
• Both the equilibrium price
and quantity increase.
The oil supply shock
A decrease in demand (e.g.
caused by economic recession)

• Any event that decreases the

quantity demanded at a
given price will cause an
inward shift from D1 to D2
• Both the equilibrium price
and quantity decrease.
An increase in supply (e.g. oil
glut)

• Any event that increases the

quantity supplied at a given
price will cause an outward
shift from S1 to S2
• The equilibrium price
decreases but the quantity
bought and sold increase.
The oil supply shock
A decrease in supply (e.g oil
shortage)

• Any event that decreases the

quantity supplied at a given
price will cause an
inward/leftward shift from S1
to S2
• The equilibrium price
increase but quantity bought
and sold decreases.
An increase in supply

• Any event that increases the

quantity supplied at a given
price will cause an outward
shift from S1 to S2
• The equilibrium price
decreases but the quantity
supplied increases.
 The oil supply shock Simultaneous/multiple shifts in supply and demand
curves

• Two possibilities as in Panels (a) and (b) below

Source: adapted from Mankiw, N.G., and Taylor M.P., Microeconomics, 3rd ed., 2014
Exercise

Discuss the case of a simultaneous increase in the demand for

and supply of petrol/petroleum/electricity at a national, regional
or, global level.
.