World Conference on Laurie Oils - Assignment Example

? OIL PRICES 28.12 Introduction In recent years there has been a big debate over movement in oil prices, with the debate centering on whether oil prices are being driven by speculative financial investment rather than fundamentals. The study has been covered by numerous researches and has generated considerable controversy. The interest given to this topic is well deserved since oil is of the highest economic significance, having micro-economic impact on growth. This is mainly because oil products are major consumables affecting household incomes. Further, the international nature of oil production, consumption and trade means that the consequences are far reaching (Wauquier & Fevennec 2001). There are a number of intrinsic features of oil supply and demand that are significant to any study of crude oil price instability. Important features encompass competing price and income elasticity, a bifurcated and complex supply response, variable data quality, single currency prizing and the interaction of multiple refined oil product market with discrete elasticity of supply and demand. Consequently they do have a shock on elasticity of supply and demand and can have an impact on the wide-ranging elasticity of the crude oil market (Williams 1996). It is generally understood that OPEC (organization of petroleum exporting counties), has the biggest oil reserves in the world, and is accountable for most of the supply and pricing of petroleum products. OPEC is a permanent intergovernmental organization which at present consists of 12 oil producing and exporting countries, as members spread across three continents of America, Asia and Africa (Taylor 2006). The 12 member’s states of OPEC are: Algeria, UAE, Angola, Qatar, Ecuador, Kuwait, Iraq, Libya, Nigeria, Saudi Arabia and the Islamic Republic of Iran. Causes of Short Run Price Movement of Oil Global oil prices have more than tripled since the year 2003, and volatility has become the rule rather than the expectation. The market price of oil is volatile in the short run. This is because of the following causes: 1. The price elasticity of supply The price elasticity of supply is a measure used to measure the connection between the change in quantity supplied and change in price (Kellick 1995). If supply is elastic, producers can raise output without rise in cost or time delay. If supply is inelastic, firms find it hard to alter production in a given period of time. The price elasticity of supply is equated to the Percentage change in quantity supplied divided by the percentage change in price When the result of this is: More than one, then supply is elastic, Less than one then supply is price inelastic, Zero, then supply is preferably inelastic and When the result is infinity supply is perfectible elastic following a change in demand. Factors That Affect Price Elasticity of Supply of Oil Several factors affect the price elasticity of supply of oil, these are: a) The spare production capacity- the spare production capacity of oil have reduced over the years, this has been one of the major reason for the rapid increase in the prices of crude oil. When there is spare capacity, businesses can expand output easily to meet rising demand pressure on cost (Wakeford, 2010). However, when this spare capacity lacks then the business cannot be able to increase production and would mean that the high prices will persist due to the scarceness of the commodity (Clo, 2000). b) The period involved in the production process – when supply is more price elastic the longer the time period that a firm is permissible to adjust its production levels. In some markets for example in agricultural markets, the quick supply is fixed and is determined generally by planting decision made mouths before, and also the climatic condition, which have an effect on the overall production (Gibbs 2010). c) Factors substitution possibility-when factors substitution is achievable at low cost, then supply will be elastic. When factors are highly specialized as in our case here then the supply will be inelastic and thus the high prices would be the order of the day. 2. The price elasticity of demand Price elasticity of demand measures the responsiveness of consumers to an alteration in price of a product (Moors 2011). It does so by comparing the percentage change in quantity demanded from a percentage change in price. The price elasticity of demand is given by multiplying Percentage change in the demand of goods and the change in the price of good. Factors That Affect the Price Elasticity of Demand for Oil a) Number of close substitutes within the market- the more (and closer) substitutes there are in the market the more elastic demand will be in response to a change in increase in the price of the commodity in question. Oil in this case does not have substitutes in some cases for example in automotives, whereby a vehicle which is designed for the use of only oil therefore the oil has somehow an elastic demand. b) Luxuries and necessities- Necessities tend to have a more inelastic demand curve, whereas extravagance goods and services tend to become more elastic. For example, the demand for vacation travel is more elastic than the demand for business travel. Therefore as oil is more of a necessity than many other goods, oil tends to be less elastic and therefore the price remains high due to the high demand (Thompson 2010). c) Habit forming goods-Goods such as cigarettes and drugs tends to less elastic in demand preference. They are such that habitual purchasers of certain goods become de-sensitive to price change. In this case, oil does not fall in the extreme case of drugs or any other addictive goods but in some way it tends to create a habit of some kind. For example, a person who is used to using private means of Transportation will find hard to use public means even if it means saving some pennies (Azhary 1984). This is due to the reason that he is used to driving himself around and will feel odd using public means. However, this is only evident in the case where the prices of oil have increased a little. 3. Enhanced geopolitical risk Geopolitical tensions are also of concern to both investors and consumers, and their impact is particularly pronounced due to the already tight market condition (Krichhene 2008). For some time reduced output in Nigeria and continued tension in Iraq have been driving upward pressures on prices. More recently the tension was coupled with renewed hostility between Turkey and Kurdistan workers party (PKK), concerning Iran’s nuclear ambitions, and political instability in Pakistan. To the extent that these types of conflicts have potential in disrupting production or delivery of oil supplies in the already tight market, these farfetched ongoing concern are reflected in higher prices of oil in the recent past. 4. Market speculation A great deal of new money has come into (and recently, out of) the oil market because it is seen as an attractive hedging commodity due to the upward swing potential compared to other commodity markets Earlier this fall, some market analyst forecasted that this segment was due to a correction as fund managers look to lock in their 2011 gains. Other saw “price magnetism” taking place forecasters test the upward bound of price, looking to break the $110 per barrel mark. We view this speculation as moving prices at the margin, but recognize that it is able to shock prices fluctuation as consequences of the essential fundamentals already at work Causes of Long Run Price Movement of Oil The prices of oil have made a remarkable change or rather upward movement over the years. The crude oil price cycle may extend over several years responding to changes in demand as well as OPEC supply. All the way through much of the twentieth century petroleum was very much regulated through production or price control mechanisms. In the post world war two periods, U.S. oil prices at the wellheads averaged $28.52 per barrel adjusted for inflation to 2010 dollars in the absence of price controls, the U.S. price would have tracked the world price averaging near $30.54. Over the same post war period the meridian for the domestic adjusted world price controls. In the early 1970s the prices of oil experienced a shock which was reportedly caused by the significant reduction in OPEC’s and operation capability. Higher prices led to marked drop in global oil demand, especially in OECD (organization for economic co-operation and development) countries and generated incentives to increase oil supply in several non-OPEC countries. These weakened OPEC control over the managerial supply of oil and created increased incentives for the cartel members to go beyond the agreed quotas, which prices to gradually decline. Oil prices, however became more volatile once more in the late 1990s and surged with increasing momentum between 2008 and mid 2008. Some of the factors that triggered this raise in prices are as follows: 1. Persistent global demand growth Energy demand growth in 2004 was more than twice the average seen in the preceding decade. Even in the face of higher prices, with demand driven by economic and population pressure and improved standard of living. The ability for this growth to weather the impact of higher price as is helped by the decline value of the dollar (making oil less expensive in foreign countries) and, in the case of the united states, the relative effectiveness of their economy as contrast to the 1970s when it took much more energy to produce each unit of gross domestic product (G.D.P). 2. Limited supply response from non OPEC sources In general, non-OPEC production has been able to keep speed with the raise in global oil consumption for a variety of reasons, such as resources exhaustion, investment, governance, and weather –related issue. Consequently, in order to meet increased demand customers must progressively more rely on a policy that includes upgrading inefficiency, development of substitute fuel sources, and drawing down existing inventories (Applewhite 1994). 3. Increased reliance on OPEC nations Without adequate contribution from non OPEC suppliers, OPEC has been progressively more called upon to produce more oil to meet projected shortfalls. Last, in an attempt to stem the precipitous decline in oil prices and trim back global inventories, OPEC nations collectively agreed to reduce output. That strategy proved to be tremendously effective in tightening the market and, together with the growth in demand turned an excess into today’s precarious balance .in September 2007, OPEC agreed to relax its output restricting and since that time has began to add incremental production to the market (Walls 1996). In the face of unrelenting increase, that production raise has had a limited blow in dampening oil prices. In the process, increased OPEC productions have resulted in decline in unused capacity and are unable to offer supplementary supplies to the market. THE 1950S & 60S PRICE STABILITY OF OIL The United States of America remained the main producer and user of oil over many years, its production remained over 50% of the worlds total until the year 1950. In addition to the United States, Indonesia and Iran, significant oil production was developed in Russia and after that in Mexico and Venezuela. Russia thanks to production in the Baku region even became the world’s prime crude oil producer around 1900 (Williams 1996). In 1911, the time of break-up of standard oil industry was developing robustly, driven by motor gasoline and fuel oil consumption in place of illumination kerosene. Oil, while still only a small part of energy supplies, was guaranteed of a strong prospect by the growth of energy provisions, was guaranteed of strong future by escalation of the auto mobile industry. The breakup of the standard oil realm put an end to the period of steadiness that had characterized the oil industry and the way in which crude oil prices had developed. Prices rose strongly until after the First World War, then they collapsed. Severe completion broke out between the major companies as the sought to conquer new markets (Williams 1996). Lastly, the principle companies entered into an accord, to share the markets between themselves and put an end to the completion they had embarked on. The agreement was known as the Achacarry Agreement, to share the markets between them and to put an end to such competition. This resulted in the new period of price steadiness. Up to the 1950s and 1960s, the oil companies continued to develop their market outlets, using the main discoveries proclaimed in the Middle East before 1939 and in Algeria, Libya, and Nigeria in the 1950s and 60s (Williams 1996). Therefore owing to these historic accounts it is then evident to claim that the prices of oil were stable in this period of time due to the following reasons: 1. The price stabilized due to the signing of the agreement of the Achacarry Agreement that sought to cool down the cut throat completion that had characterized the oil industry at that particular time. Although there was exploration being carried, in the Middle East and Africa, out which meant an increase in supply of oil, one particular company could not alter with the price, as it would have been termed as breach the agreement 2. Another cause for the stability of the price could have been due to the return to normalcy It is evident from the brief historic account that the price had been normal earlier due the increase of the use of oil over the years. These had been caused by the increased use of oil as a lighting method and the strong growth of the automobile industry. References Applewhite, H. 1994, Preceedings of World Conference on Laurie Oils: Sources,The American oil chemist Society, Walls, A.M 1996, The Economics of Energy Security, Springer Azhary, S. M. 1984. The Impact of Oil on Arab, viewed 24 December 2011 http://www.jewishpolicycenter.org/967/global-economic-crisis-arab-world. Clo, A. 2000 Oil Economics and Policy, Springer, Massachusetts. Gibbs, B. D. 2010, Micro Economics, John Willy and Sons, New York. Kellick,T 1995, The Flexible Economy, viewed 24 December 2011, http://www.odi.org.uk › Resources › Books or book chapters Krichhene, N. 2008, Crude Oil Prices: Trend and Forecast, International monetary fund Moors, K. 2011, The Vega Factor: Oil volatility And The Next Global Crisis, John Willy & sons, New York. Segal, I. 2002, Optimal pricing Mechanism with Unknown Demand, Stanford University, Stanford. Taylor, J. 2006, Principles of Economics, Cengage Learning, Boston. Thompson, R.A 2010, Economics, Addison,Wesley., viewed 24 December 2011, http://www.iiea.com/events/the-economics-of-energy-security Wakeford, J.J. 2010, The Impact Of Oil Prices Shock On The South African Macro Economy, SARB, Cape Town. Wauquier , P.J. & Fevennec, P.J. 2001, Petroleum Refining: Refinery Operation and Management, Editions TECHNIP Williams, L.J. 1996, Oil Price History and Analysis, WTRG Economics, London. Read More