What Affects the Crude Oil Prices: An Overview
In the early days, finding oil during a
drill was considered somewhat of a nuisance as the intended treasures were
normally water or salt. It wasn't until 1857 that the first commercial oil well
was drilled in Romania. The U.S. petroleum industry was born two years later
with an intentional drilling in Titusville.
While much of the early demand for oil was
for kerosene and oil lamps, it wasn't until 1901 that the first commercial well
capable of mass production was drilled at a site known as Spindletop in
southeastern Texas. This site produced more than 10,000 barrels of oil per day,
more than all the other oil-producing wells in the U.S. combined. Many would
argue that the modern oil era was born that day in 1901, as oil was soon to
replace coal as the world's primary fuel source.
Crude oil plays a major role in any
country’s economy and lives of its citizens in general. It not only supplies
the fuel for your car or truck, it also can supply the fuel you use to cook your
meals and to turn the generators that power your lights, television, and
computer. It can also be a source material for some of the clothing you wear
and the roadway you drive on. Whether you drive on asphalt or concrete
roadways, crude oil derivatives are used in more than one step of getting that
pavement laid.
Crude oil acts as an input to a lot of
industries. Hence, it is very evident that a good knowledge about how Oil
economy works, what factors affect its prices and what effect these prices have
on a Global and Country specific level is important for any decision maker.
Oil's use in fuels continues to be the primary factor in making it a
high-demand commodity around the globe, but how are prices determined?
Oil Price Overview:
After a major Oil Supply shock due to US
Shale Gas Revolution, Crude oil prices went down from their peak of $128 per
barrel in Feb 2012 to as low as $26.55 per barrel in Jan 2016. However, over
last year, Crude oil prices have slowly started moving up due to the decision
by OPEC, Russia and other non-OPEC members to extend production curbs to
rebalance the Oil market. As of writing, Brent is hovering near $70.15 per
barrel and WTI is trading at $66.14 per barrel levels.
Having said that, with the US Energy
Ministry confirming recently that the country's shale oil production has seen
steady growth in 2017, and projecting that this growth will continue into 2018,
many observers believe that the US's own production may very well be the source
of the next price drop.
The IMF predicts an average of 11.7% growth
in oil prices, to $59.90 p/b for 2018, followed by a 4.3% drop the following
year, a trend it expects to continue over the next five years.
Crude Oil Benchmarking
A benchmark crude or marker crude is a
crude oil that serves as a reference price for buyers and sellers of crude oil.
There are three primary benchmarks, West Texas Intermediate (WTI), Brent Blend,
and Dubai Crude.
Benchmarks are used because there are many
different varieties and grades of crude oil. Using benchmarks makes referencing
types of oil easier for sellers and buyers.
There is always a spread between WTI, Brent
and other blends due to the relative volatility (high API gravity is more
valuable), sweetness/sourness (low sulfur is more valuable) and transportation
cost. This is the price that controls world oil market price.
Brent Crude is a major
trading classification of sweet light crude oil that serves as a major
benchmark price for purchases of oil worldwide. This grade is described as
light because of its relatively low density, and sweet because of its low
Sulphur content.
West Texas Intermediate (WTI), also known as Texas light sweet, is a grade of crude oil used as a
benchmark in oil pricing. This grade is described as light because of its
relatively low density, and sweet because of its low sulfur content. It is the
underlying commodity of New York Mercantile Exchange's oil futures contracts.
Dubai Crude is a
medium sour crude oil extracted from Dubai. Dubai Crude is used as a price
benchmark or oil marker because it is one of only a few Persian Gulf crude oils
available immediately.
The Determinants of Oil Prices
With oil's stature as a high-demand global
commodity comes the possibility that major fluctuations in price can have a
significant economic impact. The two primary factors that impact the price of
oil are:
·
supply and demand
·
market sentiment
The concept of supply and demand is fairly
straightforward. As demand increases (or supply decreases) the price should go
up. As demand decreases (or supply increases) the price should go down.
Sound simple? Not quite.
The price of oil as we know it is actually
set in the oil futures market. An oil futures contract is a binding agreement
that gives one the right to purchase oil by the barrel at a predefined price on
a predefined date in the future. Under a futures contract, both the buyer and
the seller are obligated to fulfill their side of the transaction on the
specified date.
The following are two types of futures
traders:
·
hedgers
·
speculators
An example of a hedger would be an airline
buying oil futures to guard against potential rising prices.
An example of a speculator would be someone
who is just guessing the price direction and has no intention of actually
buying the product.
According to the Chicago Mercantile Exchange (CME), the majority of futures
trading is done by speculators as less than 3% of transactions actually result
in the purchaser of a futures contract taking possession of the commodity being
traded.
Role of Balance (Supply-Demand Equilibrium) Oil Prices
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 contrast,
when consumption outstrips current production, supplies can be supplemented by
draws on inventories to satisfy the needs of consumers. Given the uncertainty
of supply and demand, petroleum inventories are often seen as a precautionary
measure.
The relationship between prices and
inventories allows for effects in either direction. If futures prices rise
relative to the current spot level, incentives to store oil (and wait to sell
at the higher expected price) will strengthen.
Conversely, if market participants notice
an increase in crude oil storage, this increase can indicate that current
production surpasses current consumption at the prevailing price. Spot prices
will likely drop to rebalance demand and supply.
This balancing between current and future
prices and between supply and demand through inventories is one of the main
connections between financial market participants and commercial companies with
a physical interest in oil, both of whom engage in futures trading. Physical
inventory levels and price spreads over time act as a signal between current
market participants and those with longer-term exposures.
Price Cycle
Additionally, from a historical
perspective, there appears to be a possible 29-year (plus or minus one or two
years) cycle that governs the behavior of commodity prices in general. Since
the beginning of oil's rise as a high-demand commodity in the early 1900s,
major peaks in the commodities index have occurred in 1920, 1951 and 1980.
Oil peaked with the commodities index in
both 1920 and 1980. (Note: there was no real peak in oil in 1951 because it had
been moving in a sideways trend since 1948 and continued to do so through
1968.) It is important to note that supply, demand and sentiment take
precedence over cycles because cycles are just guidelines, not rules.
Impact of OPEC on Oil Prices
The Organization of the Petroleum Exporting
Countries (OPEC) is often called a “cartel” that manipulates the price of oil
for the benefit of its members. The potential for OPEC to influence the
supply/demand balance is huge. Currently, the Organization has a total of 14
Member Countries.
According to current estimates, 81.5% of
the world's proven crude oil reserves are located in OPEC Member Countries,
with the bulk of OPEC oil reserves in the Middle East, amounting to 65.5% of
the OPEC total.
Because of their high levels of both
reserves and production, OPEC member countries have attempted to balance their
own output with the demands of the global economy since the earliest days of
the organization. Sometimes, this entailed curtailing production to adjust to
weakening demand or global oversupply, or increasing production to offset
shortages.
OPEC is not only
capable of balancing the markets, but also exerting significant influence on
global petroleum markets at critical junctures to drive the price of oil up or
down. Such periods have included
- The supply glut and subsequent price crash
of the late 1980s
- Growing hostilities in the Middle East in
the early 1990s
- The economic decline of Asia in the late
1990s
- The financial crisis and oil price crash
in late 2008
- The Arab Spring of 2011; decline in oil
Supply but also weakening OPEC a little
Most recently, OPEC
intervened in the global overproduction that led to a drop in the oil prices by
some 65% off of the 2014 highs. OPEC initially attempted to allow the market to
rebalance itself, which led to further declines in oil prices and an increase
in global crude stocks
However, to quote P.J.
O’Rourke: “Certain people enter cartels because of greed; then, because of
greed, they try to get out of the cartels.”
According to the U.S.
Energy Information Administration, OPEC member countries often exceed their
quotas, selling a few million extra barrels and knowing that enforcers can’t
really stop them from doing so.
With Canada, China,
Russia and the United States as non-members, OPEC is limited in its ability to,
as its mission euphemistically states, “ensure the stabilization of oil markets
in order to secure an efficient, economic and regular supply of petroleum to
consumers.”
Thus, we see that
there are many factors which simultaneously play a significant role in
determining the Crude Oil Prices. Also, to take an extremely long view on the
Crude Oil, we’ll also have to take into account the shifting focus on Renewable
resources of Energy and rise of companies like Tesla which are challenging the
whole ecosystem of conventional vehicles. Many governments (including USA and
India) have announced long term plans to fully substitute production of
conventional fuel vehicle with Electric Vehicles. These factors will play a
major role in next few decades and will lead us to ask the question: Just like
coal in the present, will Oil be a thing of the past in 2040s?
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