Does Supply Determine Price or Price Determine Supply? A Case in the Oil Price Change

It is often said that asset prices are determined, among others, by the supply of the asset. I have been debating on this issue with the government officials and some economists for years on the housing markets of Hong Kong (Yiu, 2019). Interestingly, even economists sometimes would have this paradox and consider the relationship a direct result of the Law of Supply. However, if you take a closer look at the Law of Supply, it says the reverse:

“The law of supply is the microeconomic law that states that, all other factors being equal, as the price of a good or service increases, the quantity of goods or services that suppliers offer will increase, and vice versa.” (

It clearly spells out that the cause-and-effect direction is from price to supply. It is also tenable to consider that suppliers would adjust their quantity of supply to respond to the market price change, so as to achieve the maximum profit.

Admittedly, there can be several special reasons that suppliers do not make such positively correlated responses, they are:

  1. The suppliers’ objective is not to maximize their profits (it is sometimes coined as irrational, but indeed it can be rational in some situations);
  2. There are some constraints that do not allow suppliers to make the response, for example, a suspension of the supply chain due to embargo or pandemic;
  3. The market is highly monopolized or oligoplized, such that the suppliers can control most of the supplies for earning monopolized rent; and/or
  4. There are other market players that can affect the expectation of future asset prices, for example, when there is a futures market that may or may not involve direct delivery of the asset, but is a market for people to bet on the future prices of the asset. In addition, some politicians and government officials would also make use of their authority and influence to affect the expectations of market prices, for whatsoever reasons.

The supply of public goods is a good example of the first reason. The recent shortage of medical face mask supply is also a good illustration of the second reason. A high price may not induce a high supply in a pandemic, especially when some countries ban it from exporting.

In the recent episodes of oil price plummets, it may be a good case study for illustrating the above reasons 3 and 4. EIA (2020) provides some interesting data for our discussion. Figure 1 shows the framework that the right-hand side shows the OECD Demand and the non-OECD Demand. The left-hand side shows the OPEC Supply and the non-OPEC Supply. Their interactions result in the Spot Prices (in the middle).

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Figure 1 A Supply-Demand Framework for Crude Oil. Source: EIA (2020)

Figure 2 shows the retail prices of gasoline in the US and the real acquisition cost of crude oil, basically they trace each other closely. It is updated up to Apr 7, 2020, but includes a short-term forecast. It shows the recent plummet from about $60/b to less than $20/b, but it forecasts a sharp rebound in the real cost of crude oil in 2021.

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Figure 2 US retail price of regular gasoline and refiner acquisition cost of crude oil. Source: EIA (2020)

Is the recent plummet a consequence of oversupply? Let’s take a look at the data. Figures 3 and 4 show the OECD and non-OECD Demands, they forecast a -15% and a -9% plummets in the unit real price of crude oil in the wake of the COVID-19 pandemic. It is logical to attribute the plummet to the sharp fall in demand (consumption) rather than oversupply, as economic activities are largely restricted in most parts of the world during the pandemic. It also forecasts a v-shape rebound in the demand (consumption) in 2021.

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Figure 3 OECD liquid fuels consumption and WTI crude oil price. Source: EIA (2020)
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Figure 4 non-OECD liquid fuels consumption and non-OECD GDP. Source: EIA (2020)

Then, how about the supply? Would the suppliers cut their supplies in the wake of the sharp fall in demand? Figures 5 and 6 show the OPEC and non-OPEC Supplies, without giving any forecasts. Interestingly, it is quite different from what the mass media is telling us. It is not the OPEC+’s refusal of cutting the supply, but it is the non-OPEC’s increase in supply. First, it is notorious that the oil supply is highly oligopolized. That is what the cartel OPEC+ is implying. Yet, indeed even an oligopolized cartel would make compromises and respond positively to the market price changes. Figure 5 shows that Saudi Arabia has been reducing its crude oil production by almost -20% in 2019, even before the pandemic. It does not provide a forecast, but the news reports are telling us that a negotiation on cutting supply among OPEC+ members is undergoing. It is a clear sign that even an oligopolized cartel would make adjustments to their supply to respond to the market price changes.

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Figure 5 Saudi Arabia crude oil production and WTI percent change. Source: EIA (2020)

In contrast, non-OPEC liquid fuels production has been greatly increasing in 2018-2019. But it forecasts that the production would fall by about 2 million barrels per day, probably in response to the demand shock.

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Figure 6 non-OPEC liquid fuels production and WTI crude oil price. Source: EIA (2020)

Whether it is an oversupply or not can easily be revealed by the stored inventories (or vacant units in housing markets), Figure 7 tells a very important story that the inventories are positively correlated with the market expectation of futures prices, as revealed by EIA’s (2020) data as follows:

“What drives crude oil prices: Balance

Inventories act as the balancing point between supply and demand. During periods when production exceeds consumption, crude oil and petroleum products can be stored for expected future use. In the economic downturn of late 2008 and early 2009, for example, the unexpected drop in world demand led to record crude oil inventories in the United States and other OECD countries.”

“In this chart (Figure 7), the price of the next (prompt) month’s oil futures contract is subtracted from the price of the oil futures contract 12 months ahead. The change in this spread is then plotted over time. This difference is compared to the change in OECD petroleum inventories. The more positive the spread between the near term and longer-term contracts, the greater the incentive to build inventories. Also, declining inventories tend to go hand-in-hand with increases in near term prices relative to prices further into the future.”

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Figure 7 OECD liquid fuels inventory is strongly correlated with the futures price spread. Source: EIA (2020)

More importantly, its interpretation is that it is the futures price spread that causes the inventories, not the reverse. It reflects the above Reason 4 that the trading of the futures can purely be a bet about the future. But it is shaping the market expectations of the asset prices in the future. Figure 8 shows the increasing number of bets on futures prices since 2017.

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Figure 8 Producer/merchants long, producers/merchants short and producers/merchants net of the US futures. Source: EIA (2020)

The situation in the housing markets is similar. Pre-sales of housing units are very common in China and Hong Kong, it is a kind of forward contract (Yiu et al., 20). Even though it involves physical delivery, but the buyers can choose not to start paying the installments until the housing units are delivered. In other words, the cost of default is just the deposit amount, which is equivalent to the futures that does not involve physical delivery. In other words, sometimes the demand and supply of an asset can be irrelevant to the asset price when the futures price is shaping the market expectations of the future.

Today is a historical time for crude oil futures! It records an unprecedented NEGATIVE FUTURES PRICE! “The price of a barrel of West Texas Intermediate (WTI), the benchmark for US oil, fell as low as minus $37.63 a barrel.” (BBC, 2020) That means the sellers of the futures have to pay the buyers to buy!

It is commonly explained by the storage cost of crude oil that drives the futures price to negative. If it involves physical delivery, then the logic is tenable. Since almost all storage of crude oil has been full or expected to be full, while the consumption rate falls, it would cost a lot to find new tanks to store. Thus, it may be better to sell it out by giving money to the buyers. However, it does not explain the situation if the futures do not involve physical delivery. It may require another hypothesis.


EIA (2020) Independent Statistics and Analysis, US Energy Information Administration. Retrieved on Apr. 21.

Yiu, C.Y., Hui, E.C.M. and Wong, S.K. (2005) Lead-Lag Relationship between the Real Estate Spot and Forward Contract Markets, Journal of Portfolio Management, 11(3), 253–262.

Yiu, C.Y. (2019) Can increasing land supply suppress property prices?, Medium, Jan, 2.

Written by

ecyY is the Founder of Real Estate Development and Building Research & Information Centre REDBRIC

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