Is the Oil Price Volatility Inevitable - Essay Example

Is oil volatility inevitable? Oil is one the most vital commodity in the world today and its prices can never be stable. Unlike other agricultural and industrial products, whose supply can be adjusted to and increased to cater for increased demand the scenario seems different when it comes to oil production. Oil is a scarce resource and requires colossal sum of money to extract it .The lack of a perfect substitute for the commodity together with the time it takes to move it from the oilfield to the final consumer invariably makes its supply and demand inelastic (Industry Taskforce on Peak Oil & Energy Security, 2010). The volatility of oil prices has increased basically due the nature of the market, when market was disintegrated individual producer maximizes their output as much as the reservoir can allow so that they are able to cover for the immense cost of production and initial capital outlay (Hopkins, 2011). Generally the operating costs are usually lower than the capital costs, so that producers will continue to produce even when the streams of revenue are surpassed by the total cost. There with the market being competitive the prices in the oil industry will continue to fall to the extent that some producers are eliminated from the industry (Therramus, 2009). This will consequently lead to shortage that then pulls the prices upwards following the law of demand and supply. From a broader perspective the prices of oil may not be stable because of the following factors. Basically, oil prices are decided on organized future markets (European Brent contacts and American WTI) according to both financial and physical fundamentals (Wickham and International Monetary Fund Research Department, 1996). Physical fundamentals delineate the vibrant balance between demand and supply; which feature small short-term price elasticity, and as a result generates conditions for extreme volatility (Lipsky, 2009; Bleischwitz, 2011). Financial fundamentals on the other hand surpass the petroleum market and add to the entire operation of financial markets, whereby various types of assets encompassing oil are continually competing with each other. In this case, it is true saying that oil generates two unique demands in the financial and physical markets which encompass a demand for ‘paper’ oil and a demand for ‘physical’ oil. Furthermore, the presence of greater volatility generally is linked with arguments that markets frequently overshoot in relation to the underlying fundamentals (Lipsky, 2009,). For most observers, it would be clear that, the past years oil price swings signify price instances of overshooting. Nevertheless, this is not a valid conclusion due to the fact that modifications in the underlying economic fundamental may result to complex price dynamics. Physical handicaps on how fast oil can be extracted from the ground. Even though the reserves may be available the easiness at which extraction can take place is limited. This means that it not easy to line supply with demand such that the two are always matching. When the demand is more, the supply the prices of oil has to increase (Joint economic committee, 2007; Hopkins, 2011). The adjustment of supply to cater for the demand is usually made difficult by the fact that the costs that are involved may be too much and the exploration process, extraction and movement of the commodity takes quite some time. The costs of production have been on the increase as the oilfields continue to increase in depth. The relative lower prices of oil witnessed in the 19th century was basically due to the relative depth of oilfield but with other major companies engaging in oil extraction in other parts of the world where the oilfields are deeper then the prices of oil can not be expected to reduce (Sovacool, 2011). The difficulties that are witnessed by the oil producing companies in the move to expand the activities are a sure fact that we should not expect the prices of oil to be stable. This is chiefly because the increase in demand for oil and oil products can not be catered for by increasing supply of oil but by adjusting the prices upwards (Dargay and Dermot 2010). Today even the most efficiently run companies are finding it hard to maintain their production capacity leave alone expanding. This means there will be a permanent rise in the prices of oil and oil products .Sure the exploration of oil continues and chances of finding new oilfields are high but the sheer capital outlay and costs of extracting the oil may surpass the revenue that are projected to be received meaning very few companies would be willing to engage in such a risk adventure (Jean-Marie C, and University Paris-Dauphine, 2010). Another aspect that will continue to make the prices of oil volatile is the growth of economies of non –OECD .While in the past the demand of these countries has been low their growth of economies and per capita income means that their demand for oil will increase significantly (Hammes and Wills, 2005). This is not only expected to cover for the decreasing demand for oil by the OECD but will also shape the demand for the commodity in the coming years (Hammes and Wills, 2005). Therefore, with such unpredictable increase in oil demand then definitely it would be unthinkable to expect the prices of oil to remain stable. The cyclical economic events of boom and recession also make oil price stability a distant dream. In events when there is massive economic improvement the total global demand for oil is expected to increase, if therefore the companies engaged in oil exploration had not adequately prepared for such a scenario then a short run shortage may be witnessed with prices being pushed upwards (Welfens, 2011). During periods when there is recession the market dynamics are adversely affected with resultant feature being a short run excess in supply. The prices therefore may have to remain low and companies may reduce their their production capacity until the prices pick an upward trend again (Moors, 2011). All this brings out the technical difficulties that are evident when it comes to oil price stability. The explosive combination of restrained investment in the production of oil, geographical risks and upward demand pressure is set to lead to instability in the worldwide oil market. Furthermore, short-term price inelasticity makes certain that even miniature supply shocks leads to a high increase in the process of oil (Dermot, 2010). Research has revealed that demand is price inelastic due to the incapability, especially of the transport sector to restore oil-based liquid fuels particularly in the short run. Similarly, the supply is said to be inelastic as it takes a number of years for a boost in oil prices to feed in greater investment in oil production capability and an ultimate boost in output. In this case, these two types of price inelasticity mixed result to a powerful multiplier impact in the international oil market that is estimated by economists to be in the factor ten regions. This means that a physical supply shock as a result of price increase would lead to a price hike approximately ten times more in the short run as it would be when supply and demand were elastic. Research has revealed that energy price volatility will persist in future due to the fact that small mismatches in the supply and demand of energy generate large price swings based on the notion that there lacks a strong economic actor capable of dampening and absorbing the mismatches (Nick et al., 2010). In 1960, when the ‘seven sisters’ which includes the EXXON, SHELL, BP, MOBIL, SOCAL (Standard Oil of California) TEXACO, and GULF dictated over international oil supplies, they were in a better capacity to make certain price stability (Hook et al, 2011). Currently, there is no such group in terms of energy or oil supply thus the resultant of persistence in oil price volatility in current and in the coming years. Furthermore, OPEC (Organization of Petroleum Exporting Countries) has limited pricing influence, nevertheless, just when it holds capability off the market which necessitates major players, especially Saudi Arabia, to have spare capability to impose discipline (Lipsky, 2009; Schoen, 2005; Höök et al., 2009). Players in the oil market may have various objectives including speculation taking trading positions), price hedging, risk diversification, portfolio management, and arbitrages between products. However a single player can take part in achieving all these combined objectives. It is apparent based on the above that, it seems predictable that worldwide demand of oil will reach to a point in which it constantly exceeds supply. The result of this is that there will be a structural hike in oil prices, which is coupled with prediction of shortages of oil and a subsequent amplification in market volatility (Höök et al., 2009). Nevertheless, the underlying questions are by ‘how much, and how soon?’ The volatility of oil prices has increased basically due the nature of the market, when market was disintegrated individual producer maximizes their output as much as the reservoir can allow so that they are able to cover for the immense cost of production and initial capital outlay. References Al Jazeera English. Is OPEC Losing Control over Oil Price?" http://english.aljazeera.net/English/archive/archive?ArchiveId=6664 [Accessed December 19, 2011]. Bleischwitz, R. 2011. International Economics of Resource Efficiency: Eco-Innovation Policies for a Green Economy. Springer. Dargay, J. M., and Dermot G. 2010. World Oil demand’s Shift Toward Faster Growing and Less Price-Responsive Products and Regions. Energy Policy Vol.38, No.10, 6272 Hammes, D and Wills, D. 2005. Black Gold: The End of Bretton Woods and the Oil-Price Shocks of the 1970s. The Independent Review, Vol.5, No.9, 501-511. 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Wickham, P. and International Monetary Fund Research Department, 1996. Volatility of oil prices. International Monetary Fund. Read More