The Main Forces Driving the Market for Oil - Case Study Example

The Main Forces Driving the Market for Oil Introduction: Oil is the most efficient energy resource that is available and with the rising demand for this energy resource around the world, the prices have shot up in the recent past and as such presents a very good opportunity to study the forces active in the market for oil. Brief history of the price of oil: The trend in world prices in the last two decades seems like a roller coaster with sharp spikes and steep falls and yet it was not always like that. Prior to 1973 the price of oil remained at a fairly steady level. Events on the economic and political front were to change this scenario, wherein the nature of oil changed from that of an ordinary product to that of a product with economic and political implications around the world. The first spike in the price of oil occurred in 1974, when the price of oil shot up to more than $10 a barrel as a result of the Arab embargo on oil owing to the Arab-Israeli war in September 1973. This was a significant event in the history of oil, as it demonstrated the power of oil in its impact on world economics and politics. (Williams, L.J. Oil Price History and Analysis). The period from 1974 to 1978 world oil prices remained more or less stable and turbulence free. Prices remained in the $12 to $14 a barrel range. (Williams, L.J. Oil Price History and Analysis). However two political incidents were soon to disturb this period of calmness. The Shah of Iran was deposed in 1979 and a theocratic government with a strong anti-American stance emerged from this revolution in Iran. This was enough to trigger a sharp rise in the price of oil around the world and was compounded by the Iraqi invasion of Iran in 1980 and as a result oil prices jumped to $40 a barrel. (Sjuggerud, S. Dr. History of Oil: The Single Greatest Prize in All History). This spurt in oil prices was to have two reactions. Exploration for oil in countries outside the OPEC (Organization of Petroleum Exporting Countries) became more frenetic on one side and the OPEC countries increased production to stabilize prices leading to a drop in prices and by mid 1986 prices of oil dipped to as low as $10 a barrel with the increased production of oil outside the OPEC countries and within the OPEC countries. (Williams, L.J. Oil Price History and Analysis). In an effort to raise the low prices of oil, OPEC brought in a quota of production for the member countries and fixed a price objective of $18 a barrel in December 1986. This self enforced discipline by OPEC showed signs of failing even by early 1987, with member countries overshooting the production quotas accepted by them, leading to a drop in prices of oil below the $18 a barrel objective. This clearly showed that OPEC was unable to control prices in a supply driven market, because of the lack of discipline among the member countries. (Williams, L.J. Oil Price History and Analysis). The tensions in the Middle East in 1990, with the invasion of Kuwait by Iraq and the subsequent American led action to liberate Kuwait, was to see oil prices spike for a short period. The quick end to the conflict brought oil prices back to the pre-conflict levels. The prices continued to decline and by 1994 the prices had dipped below the $15 a barrel level, with increased production from OPEC. (The Organization of the Petroleum Exporting Countries (OPEC) Brief History). Added to this was the impact of technological advances in exploring and drilling, which were not only bringing down the cost of production, but also making it possible for more countries to exploit the available resources within the country. (OIL - Politics and Economics). The next upswing in the prices was caused by the impressive economic growth of the Southeast Asian countries. This upturn in the economic fortunes of the Southeast Asian countries, coupled with an upswing in the American economy placed increased demands on oil requirements leading to a rise in the prices of oil from 1995 to 1997 with the price of oil reaching close to $ 25 a barrel in 1997. Then followed the economic crisis in Southeast Asia in 1998 and with that the oil prices crashed, as OPEC failed to really measure the gravity of the economic recession in Southeast Asia. The price dropped to around $10 a barrel. In 1999, the price of oil started recovering with the reduction in production from OPEC. The prices rose to $25 dollars a barrel and the growing economy of the United Stares of America and other countries around the world pushed up demand and even though OPEC increased quotas, prices still held till the end of 2000 (Williams, L.J. Oil Price History and Analysis). In 2001 the weakening economy in the United States of America and increased availability of oil from the oil exporting countries outside of OPEC caused a drop in the prices of oil. The drop in prices caused by this increased production from countries outside of OPEC and the weakening U.S. economy remained despite OPEC imposing a reduction on the production quotas of its member nations. The prices further nose-dived with the terrorist attacks of September 2001 to reach levels of about $16 dollars a barrel. This led to production cuts not only within the OPEC, but also outside of the OPEC and prices climbed back to the targeted $ 25 a barrel in 2002. (Williams, L.J. Oil Price History and Analysis). Since then prices have only climbed due to a succession of events on the demand and supply side of oil. Strikes at the oil production facilities of Venezuela at the end of 2002, resulted in a substantial drop in the availability of oil from Venezuela and in March 2003 the war in Iraq and the subsequent strife there deprived the oil flow from Iraq into the world markets. This loss of oil availability from these countries was not offset by the increased production by OPEC and prices of oil. The spare production capacity of oil that hovered around the six million barrels per day in the middle of 2002 dipped to two million barrels of oil in the middle of 2003. (Williams, L.J. Oil Price History and Analysis). Additional pressures from the demand side were to come in the form of the emerging economies of China and India and other growing economies. The increased energy requirements from the increased purchasing capacity of the burgeoning middle class of these countries was to add to the problems in the availability of oil and have an impact in pushing up the prices. The last eighteen months have seen oil prices sky rocketing to near $60 a barrel due to the growing demand from the newly growing consumerism of the emerging economies and the production of oil just not keeping up with this increased in demand. (Oil market reliability: a commercial proposal.). Analysis of the market forces: The history of the price trends in oil clearly indicates that demand and supply are the driving forces behind the rise and fall in prices. When supply has lagged behind demand, prices have shot up and when supply has been more than the demand, prices have fallen. Yet, there has been a determining set of factors on the demand side and the supply side in this tug of war. Demand side factors: On the demand side there have been two factors namely the growth in population and the economic development of societies in different parts of the world. Led by China and India, the growth in population has put a strain on all the resources required by humankind and not the least on oil. Having said so much, the demand in the growth of oil has accelerated over the last decade to average 2.25% per year well exceeding the growth in population. In the early history of oil, consumerism was mainly seen in the Western developed world. Now led by China and India, the newly emerging developing nations are seeing an upward swing in their economic fortunes. This has led to increased consumer demand from these countries. This growth in demand from these economies has been in the range of 6% to 15% and is expected to rise. These factors on the demand side can only grow. The only manner in which demand side stress on oil could be to some extent reduced is by conservation of this vital energy resource. However the elevated life styles of the societies in the developed and developing nations have had a negative impact on any measures of conservation that have emerged. (Mckillop, Andrew. Oil Price Trends 2004 – 2010). Supply Side Factors: Any talk of oil supply and the first thing that springs to the mind of most people is OPEC. The problems seen in the deficiency of oil supply were neatly summed up by Michael Klare in his book “Blood and Oil” that the problem with oil was not in its scarcity, but more in its concentration in few parts of the world. (Crude arguments; Oil and geopolitics). OPEC stands for Organization of Petroleum Exporting Countries, which was formed in 1960 with an initial membership of five nations and gradually expanded to become a cartel of thirteen members, led by Saudi Arabia the country with the maximum oil resources in the world. The capacity of OPEC to control the supply of oil prices was first seen in the 1973 Arab embargo on oil and since then this capacity has gained in prominence with the lack of competition. (The Organization of the Petroleum Exporting Countries (OPEC) Brief History). The reason for this lies in that estimates of the extent of proven oil reserve held by OPEC is to the tune of eighty four percent of the proven oil reserves of the world and so the issue of the supply of oil is controlled by OPEC. (Non-OPEC Fact Sheet). The confidence of OPEC in this aspect is so strong that there is indication that by controlling the supply of oil they intend that the price of oil to be in the region of $40 to $50 a barrel, which in their eyes is the adequate compensation for this resource found beneath their soils. (Kole, J.W. OPEC Wants Oil Prices To Be 'More Reasonable'). Under normal market conditions, in such a situation, competition comes into play and in the case of a commodity, regulatory factors could also become a factor. In the case of oil it is an issue that is world wide and no single political authority has the capability to enforce regulatory factors. The developed world led by America is so dependant on oil from the OPEC countries that they have also become powerless. Direct competition to OPEC has come from countries outside of OPEC. In the last three and half decades, despite having only sixteen percent of the oil reserves of the world these countries have contributed to an average of sixty percent of the available oil. Countries like Russia, Norway and Mexico have exported oil, while countries like America, Malayasia and India have made attempts to meet part of their domestic needs. (Non-OPEC Fact Sheet). This has however led to the problem of the depletion of oil reserves in countries outside of OPEC and alarm bells are ringing that oil availability from these countries is likely to drop from 2010 onwards and reduce the impact of this supply on the availability of oil. (Bezat & Auzanneau. IEA: Non-OPEC oil production to decline after 2010). Russia has the largest oil reserves after Canada among the countries outside of OPEC. Unfortunately politics has played a role in the reduced availability of Russian oil to the world pool. Cold war era and subsequent politics was the reason behind the American hindrance of the development of the Russian oil resources. The consequence has been that the both the technology as well as the infrastructure for extraction of oil is outdated and the technology up gradation has been slow. In addition civil unrest and terrorism in the Caucasian region, through which the over land oil transportation pipe lines lie, have hindered use of these for making Russian oil supply more available. In the realm of politics, another large source of oil is Iraq, but has been a very low-key player since the invasion of Kuwait in 1990. The UN embargo against Sadaam Hussein and the subsequent political unrest in the country since the ousting of the Sadaam Hussein regime has seen the supply of oil from this nation having the fourth largest oil reserve diminishing to a trickle. (Barlett, L Donald and Steele B. James. The Oily Americans: WHY THE WORLD DOESN'T TRUST THE U.S. ABOUT PETROLEUM: A HISTORY OF MEDDLING.). Indirect competition for oil would come from the alternatives to oil as an energy resource and the picture here is bleak. Coal was the fuel of the world before oil. The use of coal creates environmental problems and technology has not been developed that allows the use of coal in an environment friendly manner. Nuclear energy has its safety and security concerns that restrict its use. Among the renewable energy sources hydroelectric sources have seen maximum use, but have its environmental limitations. Wind and wave power, biomass and solar energy are other sources of renewable energy that show potential but still are a long way off from becoming an effective competitor for oil. (Kirby, A. 2000. Alternatives to oil). Transport oil in the form of gasohol has found use in Brazil and is gradually being introduced in other countries like India. Natural gas is an efficient energy resource. Transportation of this resource is turning out to be a costly proposition. Natural gas is compressed into a liquid for transportation by, but the liquid is extremely volatile and needs specialized transport ships. Natural gas can also be piped. The laying of pipes gas has difficulties, besides cost, in that it crosses boundaries of countries and politics comes into play. Technological advances have enhanced the exploration for oil and extraction from oil resources that were not possible, as from beneath the seas. It is such advances in technology that made it possible for the countries outside of OPEC to tap their resources and on the OPEC side improve extraction techniques that have enabled a reduction in cost of production of oil. Despite this OPEC has not increased its spare production capacity to augment the supply position of oil. Profit motivation of the oil companies is also a factor in the oil market. Strategic management through lean management techniques, have caused oil companies in their drive for increased profits to reduce their storage of oil. The result has been that seasonality of oil demand and natural disasters have had a greater impact in the oil market as a result of this lack of buffer stocks. There is also the impression that oil companies have followed a make hay while the sun shines policy, like OPEC and the investigation into manipulation of oil prices is going on in America as a result of this. (Oil Company Execs Defend Huge Profits). Future Prospects: The unwillingness of OPEC to increase their spare production capacity and control the supply of oil in such a manner as to keep it at a high level means that oil prices are not going to come down in any appreciable manner. There may be however a silver lining to this dark cloud. Necessity is the mother of invention and this dark cloud will only motivate technology to find alternatives to oil and with that competition oil prices will be driven down. Still that is a long way off and till then the world is going to see the supply side dominate the oil market and keep prices high. Conclusion: Oil is not just an ordinary commodity and has shown its economic power and with that its influence on politics. The nations that control the oil resources do realize this and will continue to exploit this nature of oil. There is nothing much the rest of the world can do except to look forward to technology and the hope that it provides in providing a cost effective and environment friendly alternative to oil. Tables and Charts: Table - 1 Annual Average Crude Oil Prices 1946-Present   U.S. Average (in $/bbl.) Year Average Nominal Inflation Adjusted 2005 1946 $1.63 $16.31 1947 $2.16 $19.20 1948 $2.77 $22.91 1949 $2.77 $23.13 1950 $2.77 $22.89 1951 $2.77 $21.22 1952 $2.77 $20.74 1953 $2.92 $21.65 1954 $2.99 $22.14 1955 $2.93 $21.72 1956 $2.94 $21.52 1957 $3.00 $22.21 1958 $3.01 $20.67 1959 $3.00 $20.46 1960 $2.91 $19.58 1961 $2.85 $18.95 1962 $2.85 $18.73 1963 $3.00 $18.90 1964 $2.88 $19.23 1965 $3.01 $18.98 1966 $3.10 $18.99 1967 $3.12 $18.60 1968 $3.18 $18.15 1969 $3.32 $18.00 1970 $3.39 $17.37 1971 $3.60 $17.68 1972 $3.60 $18.95 1973 $4.75 $21.10 1974 $9.35 $37.64 1975 $7.67 $45.08 1976 $13.10 $45.77 1977 $14.40 $47.21 1978 $14.95 $45.59 1979 $25.10 $68.11 1980 $37.42 $90.39 1981 $35.75 $78.27 1982 $31.83 $65.62 1983 $29.08 $58.06 1984 $28.75 $55.03 1985 $26.92 $49.75 1986 $14.44 $26.18 1987 $17.75 $31.05 1988 $14.87 $25.03 1989 $18.33 $29.38 1990 $23.19 $35.18 1991 $20.20 $29.49 1992 $19.25 $27.27 1993 $16.75 $23.06 1994 $15.66 $21.00 1995 $16.75 $21.86 1996 $20.46 $25.92 1997 $18.64 $23.09 1998 $11.91 $14.53 1999 $16.56 $19.72 2000 $27.39 $31.61 2001 $23.00 $25.83 2002 $22.81 $25.19 2003 $27.69 $29.93 2004 $37.66 $39.61 2005 $46.47 $50.15 Source US DOE/ www.economagic.com and  www.ioga.com   (Historical Crude Oil Prices (Table)). Table – 2 World per capita oil demand and oil price trends 1971-2003      Year World population Year average Millions Average daily oil demand  Mbd �all liquids� Billion barrels consumed per year(Gby) Change on previous 3-year value (percent) World per capita average (bcy) Barrels/capita per year Year peak oil price in 2003 dollars per barrel (light volume crudes) 1971 3750 51.76 18.89 + 11.4% 5.03 USD 15 / bbl 1974 3980 59.39 21.68 + 14.8 % 5.44 USD 56 / bbl 1977 4200 63.66 23.23 + 7.2% 5.53 USD 38 / bbl 1980 4410 64.14 23.41 + 0.7% 5.31 USD 79 / bbl 1983 4650 58.05 21.18 - 9.6% 4.56 USD 59 / bbl 1986 4890 61.76 22.54 + 6.4% 4.60 USD 32 / bbl 1989 5150 65.88 24.04 + 6.6% 4.67 USD 32 / bbl 1992 5400 66.95 24.43 + 1.6% 4.52 USD 29 / bbl 1995 5610 69.88 25.51 + 4.4% 4.55 USD 25 / bbl 1998 5870 72.92 26.62 + 4.3% 4.53 USD 18 / bbl 2001 6130 75.99 27.74 + 4.2% 4.52 USD 31 / bbl 2003- 2004       ~ 6350    ~ 78.5 � 81   ~ 29 � 30 + 4.9% (3- year base) ~ 4.55 USD ~ 60 / bbl Population data/ UN Population Information Network (year average or « June » population estimate) World daily average oil demand each year: BP Statistical Review of World Energy, various edns. Peak annual oil price (3 month basis) for light volume crudes, world demand and price deflator forecasts for 2003-04 are by this author. (Mckillop, Andrew. Oil Price Trends 2004 – 2010). Chart – 1 List of References Barlett, L Donald and Steele B. James. (2003). The Oily Americans: WHY THE WORLD DOESN'T TRUST THE U.S. ABOUT PETROLEUM: A HISTORY OF MEDDLING. Time. v161 i20 p53+. Retrieved November 12, 2005. From Gale net. Web site: http://galenet.galegroup.com/servlet/BCRC?vrsn=149&locID=nysl_me_tnypl&srchtp=art&c=76&ste=21&tab=2&tbst=tsAS&atp=KE&docNum=A101580478&art=petroleum+history&bConts= Bezat & Auzanneau. (2005). IEA: Non-OPEC oil production to decline after 2010. 2005. Le Monde. Retrieved November 12, 2005. From Energy Bulletin. Web site: http://www.energybulletin.net/9073.html. Crude arguments; Oil and geopolitics. October 9, 2004. The Economist (US), v373 i8396 p78. Business & Company RESOURCE CENTER. Retrieved November 12, 2005. From Gale net. Web site: http://galenet.galegroup.com/servlet/BCRC?vrsn=149&locID=nysl_me_tnypl&srchtp=art&c=26&ste=21&tab=2&tbst=tsAS&atp=KE&docNum=A123045807&art=petroleum+history&bConts=0 Historical Crude Oil Prices (Table). Retrieved November 12, 2005. From InflationData.com. Web site: http://inflationdata.com/inflation/Inflation_Rate/Historical_Oil_Prices_Table.asp Kirby, A. (2000). Alternatives to oil. Retrieved November 12, 2005. From BBC NEWS. Web site: http://news.bbc.co.uk/1/hi/business/916492.stm. Kole, J.W. (2005). OPEC Wants Oil Prices To Be 'More Reasonable'. Retrieved November 12, 2005. From TechNewsWorld. Business. Web site: http://www.technewsworld.com/story/43784.html. Mckillop, Andrew. (2004). Oil Price Trends 2004 – 2010.2004. Retrieved November 12, 2005. From CommUnityofMinds. Web site:http://solutions.synearth.net/2004/04/02. Non-OPEC Fact Sheet. (2005). Retrieved November 12, 2005. From eia. Country Analysis Briefs. Web Site: http://www.eia.doe.gov/emeu/cabs/nonopec.html. Oil Company Execs Defend Huge Profits. Retrieved November 12, 2005. Associated Press. From Forbes.com. Web site: http://www.forbes.com/business/healthcare/feeds/ap/2005/11/09/ap2328347.html Oil market reliability: a commercial proposal. (2005). Petroleum Intelligence Weekly. V44 i30 p6 (2). Retrieved on November 12, 2005. From Business & Company RESOURCE CENTER. Web site: http://galenet.galegroup.com/servlet/BCRC?vrsn=149&locID=nysl_me_tnypl&srchtp=art&c=2&ste=21&tab=2&tbst=tsAS&atp=KE&docNum=A134814940&art=petroleum+history&bConts=0 OIL - Politics and Economics. Retrieved on November 12, 2005. From ICFAI UNIVERSITY PRESS. Web site:http://www.icfaipress.org/books/Oil_Politics_Ecnmcs_Overview.asp. Sjuggerud, S. Dr. (2004). History of Oil: The Single Greatest Prize in All History. Retrieved on November 12, 2005. From The Investment U E-Letter: Issue # 360. Investment U. Web site: http://www.investmentu.com/IUEL/2004/20040811.html. The Organization of the Petroleum Exporting Countries (OPEC) Brief History. Retrieved on November 12, 2005. From OPEC. Web site: http://www.opec.org/aboutus/history/history.htm Williams, L.J. Oil Price History and Analysis. Retrieved on November 12, 2005. From WTRG Economics. Web site: http://www.wtrg.com/prices.htm. Read More