Tuesday, January 6, 2009

Oil and gas - substitute goods

The Russian decision to cut off gas supplies from the Caspian basin in pipelines carrying gas to Europe through Ukrainian terirtory due to alleged illegal siphoning off of gas, unpaid bills and a new pricing contract, may have had the effect of contributing to the recent rise in oil prices. Since pipes across Ukraine carry about one-fifth of the European Union's gas needs, which are especially inelastic during winters, any decline in gas supply would immediately force consumers to switch to its substitute oil. This in turn forces up the prices of oil.

Oil and gas are classic substitute goods, in so far as the two kinds of goods can be consumed or used in place of one another in at least some of their possible uses. Therefore, they exhibit positive cross elasticity of demand, so that as the price of one goes up the quantity demanded of the other will increase.

Update 1
NYT has more on the Ukraine-Russia row on the gas pipeline.

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