Crude Oil Price Plunge and Government Intervention in the Fuel Market

Answer

Part (a) — Reasons for the plunge in the crude oil price [10]

The price of crude oil is set by demand and supply in a competitive global market, so a sharp fall in price must reflect some combination of falling demand, rising supply, and the elasticities that govern how large the price response is.

Fall in demand. Demand for crude oil is derived from demand for refined fuels. The COVID-19 pandemic grounded international travel and shut major cities, collapsing the demand for jet fuel and petrol; as demand for fuel fell, so did the derived demand for crude oil, shifting the demand curve leftward.

Rise in supply. Simultaneously, OPEC and Russia raised output in a contest for market share, and improvements in drilling and extraction technology lowered the cost of production. Both shift the supply curve rightward.

The role of elasticities. Both demand and supply of crude oil are price-inelastic in the short run — demand because oil is a necessity and a vital raw material with few substitutes, supply because shutting and restarting oil rigs is extremely costly. With a steep (inelastic) demand and supply, the combined leftward demand shift and rightward supply shift produce a large fall in price for a modest change in quantity.

Part (b) — Factors in deciding whether to intervene to lower fuel prices [15]

The puzzle in the stimulus is that crude oil fell 65% yet retail petrol prices held steady, prompting the question of whether the government should intervene. Assuming the government aims to maximise society’s welfare, the decision should follow a decision-making weighing of the benefits and costs of lower fuel prices against the information needed to act well.

Benefits of lower fuel prices. Lower petrol prices raise the consumer surplus of motorists. Because fuel is a major input to transport, cheaper fuel also lowers the cost of production for bus, taxi and MRT operators and for airlines, allowing lower fares and raising the surplus of the wider commuting and travelling public. At the macroeconomic level, a fall in this key input cost raises short-run aggregate supply, supporting actual growth and lower cost-push inflationary pressure.

Costs of lower fuel prices. Because demand for petrol is price-inelastic (few viable substitutes), a lower price raises quantity demanded less than proportionately, reducing the total revenue of fuel retailers; if revenue falls by more than costs, their profits decline, weakening their capacity to invest in cleaner-energy research with long-run social benefit. Intervention itself is costly: subsidising operators or capping prices commits public funds whose opportunity cost is foregone spending on infrastructure, healthcare or education, and price controls below the market level can create shortages.

Information. The decisive factor is why prices have not fallen. The government would need information on the cost structure of fuel retailers — whether non-oil costs such as wages and rentals have risen enough to offset the crude saving — and on the conduct of the few large firms that dominate the market, to judge whether stable prices reflect legitimate cost pressures or an exercise of market power. Only the latter clearly warrants intervention.

Judgement. Government intervention is justified only where the benefits of lower fuel prices outweigh the costs and the cause of the stickiness is one intervention can properly correct. The pivotal consideration is therefore information: without knowing whether sticky petrol prices stem from genuine cost increases or from firms withholding the crude-price saving, the government cannot tell whether intervention would raise welfare or merely distort an already-functioning market. This is complicated by the volatility of crude prices and input costs, which gives retailers a legitimate reason to smooth retail prices rather than track every swing — so the case for intervention is weaker than the headline 65% fall might suggest.