Streetwise Professor

The interwebs are all ablaze with the news that Chinese oil demand has collapsed, and that this is why the rise oil prices has been moderate as compared to expectations, given the size of the supply shock.

No no no no no no no (repeat ad infinitum).

Chinese quantity demanded has fallen. That’s a movement along a demand curve. “Demand has fallen” is an inward shift in the demand curve. Very, very different.

If this seems pedantic: (a) it isn’t, because it is an important distinction, and (b) whatever–it’s a pet peeve precisely because I see this mistake over and over and it leads people to extremely erroneous conclusions.

The unexpectedly large decline in Chinese oil consumption (not demand) means that Chinese demand has turned out to be far more elastic than anticipated. That is, the demand curve is flatter than had been believed.

Note that a more elastic Chinese demand curve translates into a more elastic world demand curve for oil than previously believed, especially since China represents such a large fraction of world consumption. This, in turn, means that the price effect of the supply shock due to the closure of Hormuz has been far less severe than had been anticipated.

It’s interesting to ponder why Chinese demand is apparently so elastic, and why analysts apparently didn’t realize how elastic it is.

The Slutsky equation breaks down demand elasticity into two parts, a substitution effect and an income effect. The income effect is the product of expenditure share and income elasticity. So goods that account for a large share of consumption expenditure have large elasticities, ceteris paribus. Similarly, more income elastic goods are more price elastic. So high expenditure shares or income elasticity could be part of the story.

Furthermore, the demand for oil is a derived demand–it depends on the demand for final goods produced with oil, and the supply curve for transforming oil into final (or at least further downstream) goods. Meaning that elastic final goods demand and/or more elastic transformation supply curves contribute to elastic oil demand. With respect to China, the overcapacity situation can make supply elastic and contribute to demand elasticity.

With respect to why analysts seemingly underestimated Chinese demand elasticity, I wonder if they really seriously consider it at all. Elasticities are hard to calculate, and that would be especially true in China given the dodginess of its data and the distortions in the pricing system. And the fact that analysts so frequently refer to changes in Chinese consumption as changes in Chinese demand suggests that many of them operate under the all-to-common confusion of the two, and hence don’t even think about elasticity.

There are also the usual econometric difficulties, namely identification problems–which is all about separating the effects of demand shifts from the effects of movement along the demand curve caused by supply shifts.

Sometimes the best way to estimate elasticities is a natural experiment. And that’s exactly what the Iran War has created. A sudden shock to supply with no simultaneous shock to demand allows one to trace movements along the demand curve. And that’s what Hormuz is allowing us to do now.

The elasticity issue might explain the administration’s apparent nonchalance over oil prices. No doubt pre-war within the administration the effects of a supply disruption were modeled. If those doing the modeling had a fairly accurate estimate of Chinese demand elasticity, they would have concluded that the economic fallout would be far less than widely feared. This would have emboldened Trump to proceed, and explain the administration’s what-me-worry attitude and we-can-wait-this-out approach. Relatedly, it means that the impact of the blockade on Iran is a far more pressing issue for it than is the impact of the closure on the US.

The fact that China appears to be the main loser is also a plus from the US perspective.

In order to understand what has transpired, it is necessary to adopt the right analytical framing. Confusing consumption/quantity demanded with demand is the wrong framing, and leads to incorrect conclusions. Elasticity of demand is the right framing. So ignore anyone who writes or says “Chinese oil demand is plunging” or when the supply shock reverses “Chinese oil demand is soaring.” What is really going on is the consumption moves along the demand curve. Meaning that the main analytical challenge is to understand the slope (elasticity) of that demand curve, and why it is the way it is.