The Effect of Oil Price Downturn on the Demand for Tanker Vessels - Case Study Example

The Effect of Oil Price Downturn on the Demand for Tanker Vessels and the Impact on the Global Tanker Market General Background The prices of commodities play a significant role in the global economy, and, therefore, can lead to significant fluctuations in inflation and output. Due to these, policymakers mostly examine developments in markets for commodities and consider possible prospects for the future direction of commodity prices when making forecast on inflation and output. In addition, commodity future contracts are always applied in measuring financial expectation of the market of the commodity price movements. Policy institutions and Central Banks frequently apply the futures curve in forecasting of future oil prices (Nixon and Smith, 2012). These contracts give timely information concerning expected movements of commodity price. The trade volumes of seaborne crude oil had come under huge pressure for instance in the year 2014; the total trade of crude oil was estimated at only 3% below levels. However, over the same period of 2014, the trade on seaborne crude oil raised in terms of ton-miles. Notably, China and India has been the key to supporting this trend with importation to these two nations increasing by 9% in the year 2005-2014 and, therefore, adding 5.2m BPD of crude oils (Stopford, 2009). In early 1970s, the price of oil was dirt very cheap but immediately after the crisis of oil in the year 1973, it jumped to about 58/bbl US dollars from 11bbl/ US dollars. From then the price of oil has been going up tremendously. In 2000s, oil cost 40/bbl and by 2009, it had hit 109/bbl. After a drop in 2009, it bounced back to close to 105/bbl until around June 2014. However, from then, the declining began to set in and by early 2015 the prices of oil were 49/bbl(Stopford, 2009). Therefore, because of dropping oil prices a large wave of producing oil is mounting globally, driven by booming investments, companies that are privately owned being desperate to restore their reserves. This seems they are misguided, but it is still a perception that oil should become a very rare commodity in future. In the year 2012, it would likely set a new record in history, with almost more than $600 billion to be spent globally in gas and oil exploration as well as production. For the very first time, new regions of the world all the way from sub-equatorial in Africa to Asia as well as Latin America are mostly being targeted for mass exploration(General Maritime Corporation, 2009). In addition, these volatile and low prices of oil seem to help shipping by putting cash in the pockets of consumers as well stimulating economic growth. Moreover, cheap oil keep boosting oil demand and hence, resulting to sea trade booming. It is also an excellent and presentable opportunity for the oil traders because they take advantage by holding oil in tankers with hope that future prices increase (Clarkson Research Publication, 2015). The paper, comprehensively, theories of demand and supply, oil market 6-12 months prior as well as oil price down turn, its effects for the demand of tanker vessels and also its impacts. Demand and Supply Theories (Theory of Storage and Futures Prices) The theory of storage was developed by (Working, 1949), and it is the dominating model of commodity future and forward prices. It is relating the commodity expected future prices and the current, through the optimality situation of a representative style with storage technology. The storage form attempts to equate the value of selling the barrel of oil, at the price it would probably fetch when in the market, as well to the value of carrying the marginal unit as an inventory to the coming period. Down the value chain, a gasoline distribution form might keep inventory in order to meet unexpected demand. The theory says that the positive marginal convenience yielded on inventory downturn at a rate that is decreasing as inventory rises. It was developed in order to explain the seasonal behaviour of spot and futures prices for agricultural commodities - in particular, futures prices that are below spot prices before harvests, when inventories are low and the marginal convenience yield on inventory is high. Furthermore, it was found that volatility is higher when there is backwardation, which is consistent with the effects of such a convenience yield. Working mentions that there exists very little theoretical work investigating the pricing of commodity futures using a production economy framework (Working, 1949). ModelTheory Many models built to study the effects of oil price changes on the economy begin with a production role that relates output to inputs of capital, labour, and energy. In these models , an exogenous decrease in the supply of oil reduce output directly by decreasing productivity and indirectly to an extent that minimises wages that induce movement along a curve of labour supply, changes in mark-ups of business, or even rates of capacity utilisation (Finn, 2000). These models view recessions as supply driven rather than demand driven. A supply shock in the final good market affects the ability of firms to produce the gross domestic product, which means that it directly affects either the prices or quantities of factor inputs or the production technology. Demand shocks in the final-good market, on the other hand, affect spending by the households, business, and government that purchase the GDP. However, should not be confused with the language of this paper, which refers to demand, and supply shocks in the market of crude oil. According to the above model, an oil price increase produces a recession. Several early models focused instead on the demand side effects of an oil price increase. In such models, rising in oil prices would also raise the overall level of the price level that provided the Keynesian assumption of a very rigid wages as well as reducing employment. Availability and prices of energy can be quite significant for other durable goods purchased, for instance, housing (Lee and Ni, 2002). The Oil Market 6-12 Months Prior It was believed that the market of oil was already supplied adequately. World oil spare capacity was probably at about four mbd, and that seems capable of even absorbing major disruptions from a large oil producers, for instance, Iran. In fact, the mere supply dynamics, spare capacity, and demand cannot give an explanation of the high level of oil prices at that time. At almost more than $100 per barrel, internationally, the benchmark crude Brent stands between $20 up to $25, and it is above the cost of marginal of producing oil. Only psychological factors and geopolitical and a still deep-rooted perception that oil is almost becoming a very scarce commodity, can explain the departure of prices of oil from the economic fundamentals. However,coupled with the worldwide market instability, the features of today oil market was expected to be highly volatile until the year 2015, with significant chances of an oil price downturn as a result of fundamentals of demand and supply, and probabilities of new spikes as a result of geopolitical tensions. However, it would have make hard for financial investors to devise an investment strategy that is sound and allocate capital on oil companies (Maugeri, 2012). Additionally, whatever the future, the following were presumed in the oil market before the oil downturn: • From a pure physical viewing point, there are big volumes of unconventional and conventional oils that are yet to be developed, with a no in sight “peak-oil”. The actual problems concerning oil production in the future are not beneath but above the surface, and it relates to geopolitical instability and political decisions. • Other equal things, any setback to additional oil production in United States, Iraq, as well as Canada would have a stronger impact on the oil market globally, however, considering how these nations contribute to the oil supply future growth. • The tight oil booming in the US is not just a temporary bubble, but the most significant revolution over the decades in the oil sector. It might probably trigger globally emulation over the coming decades that would bear surprising outcomes provided the fact that the majority of oil resources worldwide are still untapped and unknown. What is more, the use of shale extraction main technologies as well to conventional oilfield might dramatically increase global oil production and supply. • Aggregately, oil production conventional is also rising throughout the globe at a rate that is unexpected, although some parts of the world are witnessing a more irreversible declining conventional production. However, it was believed that the age of very cheap oil is mostly behind, but at the same time there is uncertainty of what the future oil prices level would be. Technology can turn current expensive oil into tomorrow’s affordable and cheap oil(Maugeri, 2012). To summarize, because the market of the oil was expected to remain highly volatile to 2015 and it is prone to extremely movements in that occurs in opposite directions, thus represents a huge challenge for most investors, in spite of its long and short term opportunities. After 2015, however, majority of oil projects are considered to advance significantly, and this would contribute to an even stronger build-up of the global production capacity. However, this might provoke a huge phenomenon of overproduction and thus, leads to a significant, stable dip of oil prices, unless demands of oil were to grow at a sustained annual rate, not less than 1.6 % for the entire the decade. According to the demand and supply identified, Killian (2009) showed that the function for supply shocks has tremendously diminished over time and this is in line with the evidences in Baumeister and Peersman (2013) as well as Hamilton (2011). However, this is consistent with the relationship between the economic environment and oil price changes as well as the risk premium that turned positive in the year 2000s. Oil Price Downturn Crude oil is a significant factor of production. Oil can impact significantly on worldwide inflation and output. Volatile oil prices and oil market shocks have had significant economic effects and have influenced policymaking (Hamilton 2011). At the start of 2012, the total production capacity of liquid was estimated to be about 93 million barrels per day (mbd). Almost 77 mbd of what was produced was supply capacity of crude oil. Secondly, assessment of the oil production in the future needed to take into account the synchronicity among the evolution of demand and supply that emerges from most elements. Furthermore, investment cycles for development of oil, natural gas deposits, and exploration are too long, and it averages between eight and twelve years. Before the downturn, oil speculation in the market has been claimed to have caused part of the huge and sharp increase in the oil price during the year 2007-2008. Furthermore, it is has been claimed that regulation should have been imposed so that speculation can be curbed. However, the correct definition of speculation is being debated still (Buyuksahin & Robe, 2014). However, speculation in the oil market is defined as change in the future oil and prices of spot, although it is not warranted by the key determinants of demand and supply, and it does not result to a change in the oil quantities being produced, carried over as inventory or even. It is more realistic that the aggregate assessment, by the participants in the market, of the barrel crude oil price might diverge from its fundamental value. However, it was expected that if an oil price would collapse after the year 2015, a prolonged phases of overproduction might take place as a result of production capacity expanding and production costs decreasing was also expected, unless demand of oil were growing at a sustained annual rate of not less than 1.6 percent for the entire decade. The opposite was also expected to happen. A sudden rebound of the global economy might strain the equilibrium of demand and supply of oil, especially if it is accompanied by tension caused by the geopolitical. However, this scenario supports an even stronger rush in developing of new reserves of oil, as well as production (Maugeri, 2012). The fundamental value, in turn, is the equilibrium outcome of supply and demand of oil consumption, production and inventory which in turn are functions of the state variables and of the distribution of future shocks in the economy. It is not consistent that speculation, defined in this way, would be predictable because if it were, other speculators would take bets against it and drive it away. Furthermore, it is not consistent that fundamental oil-market participants would react to speculation because if they did - by changing the amounts of oil they supply and demand -the unwarranted deviation would also be eliminated or at least minimized (Buyuksahin & Robe, 2014). Therefore, the fundamental suppliers and demanders of crude oil are being captured by the behavioral aberration in a way that leads to no change in the quantities of oil produced, consumed and carried-over. An increase in the price of oil associated with a speculation shock led to a transfer of resources, in the current-period, to the stakeholders in the oil sector at the expense of stakeholders in the rest of the economy, without affecting any other real quantities in the economy. This results in a negative correlation between oil price percentage changes and stock-market returns. Whereas, the key economic shock that is leading to a positive correlation between the stock market and oil returns is shocking to worldwide actual economic activity. An unexpected increase in the rate of economic activity would lead to an increased demand for oil. At the same time, the increased activity is translated into increased current period and future dividends and to a decrease in the discount rate through the usual countercyclicality which has been empirically documented and theoretically modeled in the literature. Symmetrically, an adverse economy-wide shock - such as the one that lead to the Great Recession - led to a lower price of oil and negative current-period stock-market returns(Buyuksahin & Robe, 2014). Effects for the Demand of Tanker Vessels The downturn in prices of crude oil has been instrumental, supporting the shipping industry with very high demand for the oil tankers. For example, the Balic Dirty Tanker Index has been able to recover from its loss in September 2014 and made a recorded growth of 24.4%. However, it is still lower by 18.4% compared to January levels. The industry analysts noted that the lower crude prices are making oil purchases more attractive. Therefore, triggers were stockpiling and thereby, an increase in demands for the tanker vessels (General Maritime Corporation, 2009). Expression of tanker demand is in ton-miles that are measured mostly as the product of the amount of oil being transported in the tankers, then multiplied by the distance over which the oil is transported. Oil tonnage shipped is mainly a role of worldwide oil consumption that is driven by economic operations and the impact of prices of oil that are long-term on the where they are located and related oil production volume. Additionally, the tonnage of oil being shipped can also be influenced by certain factors, for example, political events, pipelines, risk, and weather(General Maritime Corporation, 2009). The distance to be covered by which oil is to be transported is the more important variable element of the equation of ton-mile demand. The distribution patterns and seaborne trading that are influenced by the locations of production as well as the optimum distribution of economic of production to where it is destined for consumption and refining are determining it. Seaborne trading patterns can also, periodically, be influenced by the geopolitical events, which divert tankers from trading patterns that are normal, as well as by inter-regional oil trading operations created by imbalances of the oil demand and supply(Dikos, 2004). Oil Importation and Ship Building Market The U.S is leading in importation of crude oil globally. Since 1995, United States consumption of crude has gone up by 10%, over the same period United States crude production has gone down by an aggregate of 24.5%. Driven by the imbalance of demand and supply, U.S. importation of crude oil has increased by an aggregate of 46.2%. Tanker supply goes up with the new buildings deliveries and decreases with the older vessels scrapping. Typically, deliveries of new buildings are 18 to about 36 months after they are ordered. In every two and a half years, oil tankers normally undergo a class survey that with time becomes progressively very expensive. However, if the number of new shipping buildings being delivered keeps staying below the number of older tankers that are scrapped, the modern tonnage demand would raise, as might the rates they can command (Dikos, 2004). The freight market and newly building market are associated positively. Firms that order new ships in order to expand the sizes of their fleet during the freight boom. In the tanker shipping sector, demand for new vessels is reflecting the need for shipping capacity. The many orders of new building ships from tanker shipping firms showed that they were optimistic that the growth of seaborne trade and increase in future freight rates. Therefore, a hypothetical downturn of oil price impacted significantly. From the business operations perspective, prices of new building of ships have had an effect of stabilisation in the tanker shipping (Dikos 2004). Immediately the shipping services demand goes up, shipping firms always make the decision to increase their capacity of shipping by making orders for new ships. In addition, at the same time, the rate freight increases because of the high demand for ship services. Therefore, high freight rate shows that shipping firms can earn higher more than the normal profit. Moreover, when the seaborne demand rises, profit level and high freight rate affect shipping firms to place many orders for new ships. In this regard, the increase in new ships demands, the prices in the building market for shipping also increase. It means, therefore, capital cost of shipping firms’ increases. Such increase in the prices of new ships can be seen as a stabilizer to set a kind of a barrier for shipping firms for profit excessive. Trade Volume, Fleet Size, and Vessel Prices As seaborne volume is growing, ship owners require their fleet adjustment by size in order to meet the demand market. Freight rate performs a key function in the shipping market of the tankers as high freight rate is affecting ship owners decision on the capacity of their shipping. The moment freight rate goes up; the owners of the ship make more order to build new ships, and the price vessel would increase. In addition, the same time the prices of second-hand ships rises because the second-hand ships keep substituting newer building of vessels and can be easily deployed to shipping market in a short period relatively(Dikos, 2004). Tanker shipping service that is provided by the shipping firms targets to meet the sea transport services demands. Carriage of goods, for instance, oil, only takes place when there is a high transportation demand. The services of tanker shipping derive demands from the energy trade in the seaborne. Therefore, when there is increasing demand for shipping service of tankers, freight rate would increase. Hence, seaborne trading is very important variable in market of the tanker shipping (Dikos, 2004). Impacts of Oil Downturn on the Tanker Market The super tankers daily earnings on the benchmark of the Middle East to Japan route did hit a six-year high in the mid of December 2014, in part due to the republic of China building up its strategic reserves on the back of low prices of oil. However, according to aggregated data from the Baltic Exchange, the daily income reached $97,489 on the benchmark of the Middle East to Japan route that is the highest levels of year 2008. With the dropping of oil prices to below $60 a barrel for the first time from May 2009 down to almost 50 percent over the last six months only China had already moved to construct its strategic reserves. In addition, between the period of January and November in 2014, China did import about 6m barrels per day on averagely, up to 500,000 barrels in the same period in 2013 (General Maritime Corporation, 2009). Relentless production that emerged from the United States shale oil fields had also started to have tanker market transformational impact as well. United States seaborne crude importation was down by 43% since 2006 and went down by 9 per cent in 2014 only, according to the broking firm known as the Clarkson Research Services, (2010). Exportation from the West Africa and Middle East have rather made their way to countries such as India and China that are routes, which are much longer but very lucrative. This means that seaborne trades continued to boom wrecking in much income to shipping firms. However, the oil industry could receive a further boost in the few coming months as the oil surplus grows. The downturn in the prices has enabled traders to seek, buy more oil for storage on tankers and hoped to get profit from sales in the future. Analysts and Ship owners are very optimistic that rates would remain slightly above $40,000 for many years because of very low number of new building ships on order. In addition, while, in the shipping market, the freight market is the key source of income for the oil tanker shipping activities. The revenue generated in the market gives financial support to oil tankers shipping firms to acquire new ships as well as second-hand vessels that serve the demand for booming shipping services. Beenstock (1985) suggested that the second-hand vessels and the new building are being substituted for each other because they are similar type of assets. In an event of the new building deployment, the Market of Tanker Shipping ships can be required to wait for a number of years after making new orders, while the lead-time of deploying a second-hand ships to the freight market are very much shorter. However, at the time of freight booms, the shipping firms prefer the second-hand vessel and therefore become a good option of adjusting their capacity for shipping in order to satisfy the increasing demand for tanker shipping services (Goulielmos, 2009). Impact on Tankers’ Investment The oil industry and tanker market tends to raise investment in gradual manner as the price of crude oil rises, but the moment new investments begins, they seem hard to stop, even when crude oil prices and consumption suddenly collapse. In other words, the oil industry is behaving like an elephant running: it begins very slowly, but the moment it gets going, there is no one able to stop it. In fact, when an oil company is spending its budget gradually, the investment is assuming a life of its own, and it becomes unprofitable to block the spending, especially when hundreds of millions of dollars have already been spent. However, their need to obtain a return economic on capital that is already invested takes priority over entire consideration unless there are changes that are dramatic in the market situation. To complicate matters, tankers made contractual commitments with the nations owning the oil deposits and, therefore, that often make it hard to reduce or block the spendingafter oil downturn (Hamilton 2011). RS PlatouReport on Shipping Platou reported that in the shipping segment, the market of the crude tanker most clearly indicated how the shipping industry turned their fortunes in 2013. The first half 2013 was marked by declining oil trade globally for more than 3 percent, as all key importing nations reduced imports as a result of weak demand or very high inventories. The outcome was a predictable collapse of the market, with utilisation feet falling to an estimated 80 percent, the lower level in almost 15 years. However, fundamentals started to improve at a slow rate during the summer, as increasing oil demand spurred seaborne trade while feet capacity fastened out. In summary, for the full year in 2013 it is estimated that tonnage demand rose by almost more than 3 percent and this happened in the second half of the year, and the feet capacity increased by 4 percent (RS Platou Report, 2014). However, with the purchase and sales of used ships, the owners of the ship are in a position to restructure their fleets that exist or exit the market in response to the demand that keeps on changing (Strandenes, 2002). As the second-hand ships demand goes up during the freight booms, the vessel market for the second-hand is also closely related to the freight market. During the time of a high rate of the freight, the demand for second-hand ships vessels were also high as shipping firms deployed such ships in order to earn higher than the normal profit. Hence, the price of second-hand shipping tankers always goes up during the time of freight boom and fall during the time of depression of freight (Lun&Quaddus, 2009). On the other hand, low prices of vessel are usually corresponding with the low rates of freight. Conclusion In conclusion, as far as there is oil downturn companies are busy replacing their reserves hoping for increase in oilprice. However, this can be a challenge and can reachcritical dimensions over the coming decades because it can bring difficulties in accessing the reserves of the huge oil-producing nations, for example in the Persian Gulf. Thus, the objectives of replacing reserves, and maintaining or increasing future production of oil and gas, often override purely economic considerations. Furthermore, when prices of oil and its demand collapse, the industry of oil tends to have a perception that the collapsing is just a short-term phenomenon. So it tends to slowly cut initiatives that are new, but finds more hard to impede those that had been already initiated, but unless the downturn keeps persisting for a sufficiently long time. However, it is more for oil tanker market to defer already scheduled investments instead of blocking initiatives already began. However, due to the asynchronous relationship among the evolution of demand and oil prices as well as production development, it misleads to make predictions that are long-term of about twenty years or even more without having an actual tool for evaluating the political decisions, as well as the evolution of technology and prices. References Baumeister, C& Peersman, G. 2013. “Time-Varying Effects of Oil Supply Shocks on the US Economy”, American Economic Journal: Macroeconomics, 5(4), pp. 1—28 Beenstock M (1985) A Theory of Ship Prices. Maritime Policy Management, 12(3):215–225 Buyuksahin, B. & Robe, M. 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