The Reason of Changing Price and Supply: Oil Market - Assignment Example

Investigate an oil market and explain the reason of changing price and supply and demand Oil markets have become increasingly volatile, thus causing a great concern in the world economy in recent times. Fluctuation in oil price has an immediate cascading effect on all other spheres of economy. Oil is undoubtedly the most powerful currency in the modern world for the dynamics of oil markets not only affect commerce, but have far reaching and extremely significant consequences in international politics. On April 21, 2008, the price of New York crude reached a record high of $118.05 per barrel. The reasons attributed to this unprecedented rise are unrest in Nigeria, weakness of the dollar and the reluctance of OPEC to increase short-term output.1 It took merely one more day for oil price to climb a steeper high at $119.37 per barrel in New York on April 23, 2008. Danny Fortson mentions in his report published in ‘The Independent’ that this increase signals gloom for the world economy. With this increase, the price has now risen five-fold than it was at its lowest in the last five years. Such a phenomenal rise in the price of oil has led politicians and economists all over the world to speculate that the global economy might soon to hit an all time low with the unstoppable rise in the price of oil as seen off late. The head of the International Energy Agency, Nobuo Tanaka warned that the soaring price of oil may be what tips the global economy into recession. Slowing economies in Western Europe and America are already an indication of the far reaching effects of a steep rise in oil price.2 The mechanism of control of oil price is an economically and politically complex task. Oil prices over the world are controlled by The Organization of Petroleum exporting countries (OPEC). Formed in 1960 by Iran, Iraq, Kuwait, Saudi Arabia and Venezuala, OPEC today has expanded to eleven member countries that also include Qatar, Indonesia, Socialist Peoples Libyan Arab Jamahiriya, United Arab Emirates (UAE), Algeria, Nigeria, Ecuador and Angola. As mentioned on its official website, OPEC’s main objectives is to ‘co-ordinate and unify petroleum policies among Member Countries, in order to secure fair and stable prices for petroleum producers; an efficient, economic and regular supply of petroleum to consuming nations; and a fair return on capital to those investing in the industry’.3 Dr. Steve Sjuggerud asserts that the history of oil pricing has seen a constant upheaval. In the 1970s, price fluctuated due to the Arab-Israeli War (Yom Kippur War) in 1973, and then due to the Iranian revolution in 1979. In the 1980s, the world observed perhaps the sharpest, and close-necked peak and fall in oil price. Prices shot up in the first half of the eighties and climaxed with a dramatic decline thus again pushing the world economy in an uneasy situation. In the 1990s, the world saw how serious the oil price and control business was all about, when an infuriated Iraq invaded Kuwait and ensued in a dramatic, politically stimulated Gulf War.4 James Williams, in his detailed analysis of the history of world oil markets says that Oil prices, like any other commodity, are prone to fluctuate in times of shortage or oversupply. After the 1980s, when oil reserves were discovered in Alaska, a quarter of U.S oil supply was sourced from Alaska and thus the dominance of OPEC relatively declined. Strict price controls have ensured that the U.S. petroleum industry did not succumb to international fluctuations. In the post World War II era U.S. oil prices at the wellhead averaged $24.20 per barrel (adjusted for inflation in 2006 dollar rate ). Without price controls, however the U.S. price would have been similar to the world price that averaged $26.16. During the same time, the average domestic and the adjusted world price of crude oil was $18.53 (adjusted for inflation in 2006 dollar rate). Thus, oil prices have gone beyond $18.53 per barrel for only half the time from 1947 to 2006. The current level of prices can be attributed to a number of factors, the chief being a weak position of the U.S dollar and the consistent, fast growth in Asian economies and their petroleum consumption.  The 2005 hurricanes and U.S. refinery problems associated with the conversion from MTBE as an additive to ethanol are also reasons for the price rise.5 Just like other commodities, the price of oil is also governed by the fundamental Supply and demand concept of economics. The correlation between price and how much of a good or service is supplied to the market is known as the supply relationship. Price, therefore, is a reflection of supply and demand.6 Crude Oil prices ranged between $2.50 and $3.00 from 1948 through the end of the 1960s. The price oil rose from $2.50 in 1948 to about $3.00 in 1957. When adjusted in 2006 dollars, the crude oil prices fluctuated between $17 - $18.  This approximate 20% price rise just kept up with inflation.  Throughout the post war period exporting countries found increasing demand for their crude oil but a 40% decline in the purchasing power of a barrel of oil.  In March 1971, when the Texas Railroad Commission set pro-ration at 100 percent, the balance of power shifted.  Texas producers were no longer censured in the quantity of oil that they could produce.  This also meant that the power to control crude oil prices shifted from the United States (Texas, Oklahoma and Louisiana) to OPEC.  Crude oil that was about $3.00 per barrel in 1972, cost four times higher by the end of 1974 at over $12.00. Syria and Egypt attacked Israel on October 5, 1973, thus initiating the Yom Kippur War, that later became famous as the Arab Oil Embargo. U.S, along with many other Western countries expressed their support for Israel. with consequently, many Arab exporting nations imposed an embargo on the countries supporting Israel. While Arab nations decreased production by 5 million barrels per day (MMBPD) Though about 1 MMBPD was made up by increased production in other countries, the net loss of 4 MMBPD extended through March of 1974 and represented 7 percent of the free world production.  After the the Arab Oil Embargo, when prices increased 400 percent in merely six months, it was evident that the ability to control crude oil prices had gone from the U.S to OPEC.7 Oil price fluctuations also have a profound impact on the economies the world over and are major reasons for fluctuations in currency rates. For example, in the currency market, the Canadian Dollar has emerged as the only biggest beneficiary of rising oil prices is the Canadian Dollar. As of January 2004, Canada's total proven crude oil reserves stood at 178.9 billion barrels trailing only Saudi Arabia, which has the world’s highest quantity of proven crude oil reserves. Alberta province is said to house the majority of Canada’s oil reserves and according to the estimates by some analysts, the sandy region could have almost 300 Billion barrels worth of crude oil. This amount is sufficient to cater to US needs for over 40 years. Though till recent times the cost of extraction was prohibitive (as high as $15-$20 per barrel due to the need for massive filtration equipment), recent advances in extraction technology have lowered the price to only $9 per barrel. This makes the Alberta Oil Sands venture highly competitive in the present market prices. The energy sector comprises 8% of the Canadian GDP, though its indirect contribution to the Canadian economy is far greater. Therefore, if oil rises the CAD is likely to closely follow.8 On the other hand, the oil price fluctuation has negatively influenced Japanese currency. Japan lacks domestic sources of energy and at 99% dependency on imports, it is one of the world’s largest net oil importers. Compared to Japan, US dependency on imports is relatively low in that it imports 50% of its required share. This makes Japan extremely sensitive to changes in oil prices. Japan cannot switch to nuclear power to meet its energy requirements, because it also is a huge net importer of uranium for its nuclear power plants. In 2003, the country's dependence on imports for primary energy stood at more than 79%. 50% of Japan’s total energy needs were delivered by oil, 17% due to use of coal, 14% each from nuclear power and natural gas 14%, and 4% hydroelectric power Only 1.1% of energy demands were met with use of renewable sources. Thus, it is all too evident that when oil prices hike, the Japanese economy immediately suffers.9 There are many reasons why the oil market is in a state of constant upheaval. It is evident that the price of oil is extremely difficult to balance, as can be seen by the sharp price swings since OPEC was founded. Price fluctuations can be blamed on international politics, production, export and import policies of the OPEC and non-OPEC countries, etc. Another reason for such price fluctuation is that OPEC members do not always have identical interests and so the member countries often find it difficult to reach consensus on strategy. For example, those countries that have relatively small oil reserves, or others like Iran and Nigeria with large populations but few resources often push for higher prices. On the other hand, large producers like Saudi Arabia and Kuwait, that have massive reserves but a relatively small population are anxious that high prices may accelerate technological change, the consequent development of new deposits, thereby ultimately decreasing the value of their oil in the ground. As the world's biggest oil consumer, U.S often focuses on Saudi Arabia and Kuwait when lobbying Opec to raise or maintain production in order to ensure price stability.10 However, Andrew McKillop, in an article written in 2006, had a different opinion with regards to the unrestrained growth of oil price. He said that Price elasticity had nothing to do with the oil market, as the dynamics of the oil market showed a pattern that did not confirm to the theory of price elasticity. McKillop observed that contrary to what commentators predicted, the very high oil prices did not devastate the world economy as it was popularly predicted . On the contrary, the economy and oil prices grew together in remarkable symbiosis and interactivity since early 1999 when oil prices were at their lowest in recent times. Since then, using nominal dollars (unadjusted for inflation), prices went up by about 575% He argued that price elasticity always has an abstract underlying notion of ‘satisfaction’, and ‘substitution’ and none of these two factors could be attributed to the vast majority of oil and gas users. ‘Nobody uses oil and gas ‘for the fun of it’, or at least very few persons’, he pointed out and went on to argue that the famous ‘hi-tech emerging new energy’ substitutes and alternatives don’t exist either in the real economy. He concluded that economic theory notions of ‘elasticity’ don’t apply in large measure and fail to explain the continued high demand ins spite of the increasing oil price.11 In a research paper presented by M. J. Hwang and C.W Yang paper expands the elasticity theory first proposed by Greenhut, Hwang and Ohta (1974). The demand and supply functions of the OPEC cartel have been discussed.  The paper says that the cartel’s pricing policy is largely affected by its aggregate demand curve and related elasticities.  Elasticity theory sheds light on the maximal price a cartel can extract under a stable demand structure. To estimate the demand relations, the researchers used the data from The Annual Energy Review and The Economic Report of the President. The sample period was chosen from 1949 to 1998. The preliminary results showed that market adjustment through price elasticity of demand would itself create a local equilibrium for the OPEC.  They suggested that oil-consuming nations promote policies encouraging alternative fuel use, conservation and increased production of domestic oil.  The degree of monopoly power could be reduced by these measures, as the demand becomes more elastic.  Most importantly, these measures would shorten the painful cycle of market adjustment suffered by oil-importing countries through increasing elasticity.  With higher elastic demand in the long run, oil-importing countries would enjoy lower fuel cost, as the price of crude oil remains low.12 Environmental regulations like the EPA federal fuel oxygenate requirement had divided regional oil and fuel markets. This has led to differentials across regions, which, in turn worsens the seasonal price fluctuations. Petrol and diesel prices are most immediately affected by the volatility of oil markets and governments all over the world try and take drastic measures to keep the consumer away from the price burn. Thus simply because retail prices are slow to change when oil prices collapse (or rise), does not mean that retail gasoline markets are uncompetitive. This is rather an indication of the inelastic demand for gasoline. One reason that the demand for fuel is inelastic could be that fuel is a smaller share of household budgets. The reason for the current price boom could be attributed to China's imbalanced and subsidized demand, made all the more grave due to uncertainty in the Middle East, Venezuela, and Africa. Lastly, the fact that petroleum is a non-renewable source, with a very limited supply cannot be ignored. Though technological change has helped us locate more oil reserves, to make practical use of these, and ensure a renewed supply of crude oil obtained from the reserves located with the help of technology is still a long way and a lot of expenses away. When the world is actually able to use the oil from the reserves speculated to be rich in crude oil reserves, perhaps the world markets will be flooded with a generous supply, leading to a massive collapse in prices. Such a scenario is exactly what preceded the Gulf War in the 1990s. OPEC's inability to sustain a cartel further bruised the price decline. Price hikes indicate expectations of future scarcity relative to demand and risk.13 According to a report in The Business Day in November 2006, the International Energy Agency (IEA) had warned that oil price could shoot up to $130 a barrel by 2030 if energy investment and government policies fall short. Merely two years later, the prophecy seems determined to turn a reality all too soon. IEA had made the statement at its annual World Energy Outlook. It had reasoned that consumers had to deal with continuous price hikes as the investment in new supply was too slow to meet increasing demand. Approximately $4,3-trillion were must to be invested in oilfields and refineries by 2030 and it is far from certain that this will happen to meet the world’s oil demand, the IEA had observed in its report. 14 Thus, in conclusion we can say that the volatility of oil markets influences not just the price of the commodity, but the economy the world over. If immediate measure are not taken to control the upward swing, global economy may submit to a disturbing lull as never observed before. Reference: 1. ‘Oil price shoots past $118 for first time’, AFP, Times of Oman, April 22, 2008, viewed on April 23, 2008, URL: http://timesofoman.com/inner_cat.asp?cat=4&detail=16145&rand=usSZNm3gHL0A26duPc80rWEYKQ 2. Fortson, Danny, April 23, 2008, The Independent, ‘Surge in oil prices prompts warnings of global recession’, viewed on April 23, 2008, URL: http://www.independent.co.uk/news/business/news/surge-in-oil-prices-prompts-warnings-of-global-.htmlssion-814116.html 3. The Organization of the Petroleum Exporting Countries (OPEC), Brief History, OPEC official site, viewed on April 23, 2008, URL: http://www.opec.org/aboutus/history/history.htm 4. Dr. Steve Sjuggerud ‘History of Oil’, The Investment U E-Letter: Issue 360 Wednesday, August 11, 2004, viewed on April 23, 2008, URL: http://www.investmentu.com/IUEL/2004/20040811.html 5. Williams, James, History and Analysis, WRTG Economics, viewed on April 23, 2008, URL: http://www.wtrg.com/prices.htm 6. ‘Economics Basics: Demand and Supply’, Investopedia, viewed on April 23, 2008 URL: http://www.investopedia.com/university/economics/economics3.asp 7. Williams, James, History and Analysis, WRTG Economics, viewed on April 23, 2008, URL: http://www.wtrg.com/prices.htm 8. ‘Trends in FX-What Happens to Currencies If Oil Goes to $60?’ FXCM- Forex Capital Markets, viewed on April 24, 2008, URL: http://www.fxcm.com/if-oil-goes-to-60.jsp 9. Lien, Kathy, ‘Commodity Prices And Currency Movements’, Ivestopedia, viewed on April 24, 2008, URL: http://www.investopedia.com/articles/forex/06/CommodityCurrencies.asp 10. ‘OPEC- Oil Cartel in Profile’ 18 October 2007, BBC News, viewed on April 24, 2008, URL: http://news.bbc.co.uk/1/hi/business/3768971.stm 11. McKillop, Andrew, ‘What Happened to Oil Price Elasticity?’, April 25, 2006, Financial Sense Editorials, viewed on April 23, 2008, URL: http://www.financialsense.com/editorials/mckillop/2006/0425.html 12. Hwang, M.J, Yang, C.W, ‘Unstable Price Elasticity and High World Oil Prices’ viewed on April 24, 2008, URL: http://www.iaes.org/conferences/past/philadelphia_52/prelim_program/d00-1/hwang-yang.htm  13. Lynne Kiesling, 2005, ‘Summary of reasons why oil and gasoline prices are currently so high’, Knowledge Problem, viewed on April 24, 2008, URL: http://www.knowledgeproblem.com/archives/001385.html 14. ‘Low investment level to keep oil prices rising’, Reuters, published on the World Wide Web on November 8, 2006, Business Day, viewed on April 24, 2008, URL: http://www.businessday.co.za/articles/world.aspx?ID=BD4A312789 Read More