The Price of Oil - Essay Example

Executive summary: This paper shows the trends in the price of oil since 1999 and the global demand and supply of oil. It identifies the causes thathave led to the associated situations in the past as well as currently. The price of oil has been rising steadily since 2002 and the world is unlikely to see any change in this trend. The major reasons put forward for this situation are the rising global demand for oil particularly in economies like China and India which are seeing rapid growth in their economies, the production of oil growing at a slower pace and the reserves of oil being depleted. Since this rising prices is inevitable, the major countries will need to find alternative sources of energy to protect themselves from the impending doom of disaster. Introduction: Oil is the ingredient that drives the planet; it is as essential as air and a key source for almost every product from construction material to transportation to clothing. But the hard fact is that the supply of oil is finite and eventually it will be depleted and demand will outstrip production capacity. Increasing demand along with diminishing supply has already begun to drive price upwards. As prices are rising, new supplies are emerging in an effort to reduce consumption. "The rate at which consumption levels are rising, it is predicted that the world's oil supply will be exhausted within the next 40 years". (Guinness Atkinson Funds, "Future of Energy"). Despite price increases globally, "the demand from emerging markets particularly China and India, are driving up worldwide consumption dramatically" (Guinness Atkinson Funds, "Future of Energy). Global Demand and Supply of Oil: 2002 2003 2004 2005 2006 Total Demand 77.9 79.2 82.0 83.3 85.0 Total Supply 75.2 77.8 81.3 83.1 84.8 Source: International Energy Agency-Monthly Oil Market Report, ( 2006) As can be seen by the above graph, demand and supply both have been rising over the years, but the growth in supply has not been able to keep pace with the demand growth and hence an increase in prices. On the supply side, there are three factors that are responsible for the current situation. "Firstly, non-OPEC production capacity has been growing over the years. In recent years, the former Soviet Union supply has been growing annually at a rate of about 0.5 million barrels per day. However, this growth had mainly come from repairing tired infrastructure rather than new exploration and this sort of growth rate is and will be hard to sustain. In addition to that, West Africa, Canada and Brazil have seen another 0.5 million barrels per day annual growth in production capacity. But like the former Soviet Union, the future looks bleak regarding the maintenance of this growth. The output from the U.S. and North Sea is also shrinking. Secondly, the growth potential in OPEC production capacity is becoming smaller. Currently, most of OPEC, with the exception of Saudi Arabia, is operating at near capacity. Thirdly, since 1998, OPEC has been quite effective in keeping supply and demand matched, in addition to keeping the world oil supply a little tight. It is this combination of strong demand, slow non-OPEC production growth and effective OPEC supply management that has been the major driver of recent increases in world oil prices. On the demand side, the surge in global economic activity has led to an explosion in demand for oil and hence the world is facing an oil demand growth shock"(Guinness Atkinson Funds, "Future of Energy"). The major demand is coming from the developed world particularly the US, China and other economies in Asia. "China is in a phase of rapid energy-intensive industrialization and will continue to be one of the key consumers of oil in the coming years"(Oil Market Report, International Energy Agency). Behavior of Oil prices: The Asian Financial Crisis hit the world in mid-1997 and had a devastating effect on the major economies of the world. Even in the face of this crisis, "OPEC increased its quota by 2.5 million barrels per day"(Energy Economist Newsletter, "Oil Price History and Analysis"). Since the Asian economies had been hit by the crisis, there was slowdown in their consumption and demand for oil and hence the increased supply and decreased demand led to a glut in the market with prices of oil plummeting. "The low prices triggered a response from OPEC whereby it decided to decrease its quota in April and July 1998" (Energy Economist Newsletter, "Oil Price History and Analysis") "Prices started showing an upward trend in early 1999 and continued reduction in quotas by OPEC resulted in the oil prices finally reaching above $25 a barrel"(Energy Economist Newsletter, "Oil Price History and Analysis"). The growing economies of the world continued in demanding oil and the prices kept rising throughout the year 2000. "Since prices had risen, OPEC decided to increase its quota and did so in April, July and November respectively"(Energy Economist Newsletter,"Oil Price History and Analysis"). In 2001, the prices fell sharply because of the September 11 attacks in the US and in turn the economic weakness. OPEC and other non-OPEC producers including Russia decided to decrease production in early 2002 because of the dismal scenario. Other than that, there was a strike in Venezuela at PVDSA, which also caused production to fall sharply. The decrease in the world supply had the required effect and prices rose and continued to do so in 2002. (Energy Economist Newsletter,"Oil Price History and Analysis") In 2003, just when production in Venezuela started to gain momentum again, war in Iraq started. The Asian demand for oil coupled with the US economy surfacing again after the 2001 attacks and demanding oil led to the attrition of excess oil production capacity. In the wake of this, prices rose and have been rising continuously ever since, till to date. (Energy Economist Newsletter, "Oil Price History and Analysis") Factors responsible for the trend in oil prices: Explosion in demand: The biggest consumers of oil namely, United States and China are demanding so much oil because of growth in their economies as well as lax monetary conditions prevailing in their countries. (The Economist (2005), "The Leaders: Oiloholics"). Countries like India with its large population is also all set for strong economic growth and oil is a key essential for that. Such burgeoning demand and relatively low interest rates are causing oil prices to rise tremendously. Cheap availability of oil in the United States: Since oil is so cheap in America, the natural response is more consumption and utilization. This dependence on oil not only leaves the economy more vulnerable to a supply shock, it also pushes up prices for the rest of the world. (The Economist (2005), "The Leaders: Oiloholics"). Depreciation of the US dollar: Dollar depreciation is also one of the reasons why the prices of oil have started to rise since 2002. (Anthony Dickman and James Holloway, Economics Analysis Department (2004), "Oil Market Developments and Macroeconomic Implications") Reserves of oil supply: The older fields are maturing and declining while the new discoveries are being made in smaller fields. Upheavals in economies: Terrorist activities in Saudi Arabia, financial difficulties of the Russian oil company, Yukos, political tensions in Nigeria and Venezuela and hurricanes in the vicinity of the gulf of Mexico have all played havoc with the supply of oil and in turn resulted in an increase in prices. (Anthony Dickman and James Holloway, Economics Analysis Department (2004), "Oil Market Developments and Macroeconomic Implications") Under investment in the oil industry: Investors are not willing to invest in the oil industry to increase supply even in the face of rising prices because they believe that its risky as "oil prices are volatile and fell to less than $10 a barrel in the previous decade" (The Economist (2005) "Oil in troubled waters"). "Under the new "price paradigm" the price of oil is now permanently higher than it was 10 years ago because previously whenever there had been disruptions in the oil supply for whatever reasons, OPEC countries particularly Saudi Arabia prevented the market from overheating. These countries could do so because they had idle capacity and maintained a buffer that would come in handy in times of supply crisis. Saudi Arabia used to pump in oil at an excessive rate to prevent an oil shock and assisted in keeping prices stable. But the cushion maintained by the OPEC is now on the decline for the past some years because OPEC has not been investing adequately to keep pace with the growing demand for oil. Thus the gap between demand and supply is expanding and continuously pushing price upwards. The other reason for the price hike is that producers are under the chimera that oil is in abundant supply and the spare capacity built years ago will continue to benefit them for many more years to come; this belief has led to complacency and very little investment in the exploration of oil" (The Economist (2005) "Oil in troubled waters"). Other than that, it seems that the economies of the world have become immune and are faring quite well in the face of exorbitant oil prices. This attitude is not providing the investors the incentive to start investing in the oil industry. "Lastly, the past showed the trend of the contracts for delivery of crude for months or years ahead staying low and constant even if the spot price rose due to some short-term disruptions. But in the recent past, the trend changed and now even the distant futures have tended to spurt up" (The Economist (2005) "Oil in troubled waters"). All the above reasons have led to the conclusion that oil prices are high, more so than ever before and are here to stay. Conclusion: Oil is the most talked about issue today. The world is facing a dilemma of falling supply and rising prices and yet no curb in the demand and consumption of oil. Even though supply is increasing with demand, it is doing so at a slower pace and the million-dollar question that needs to be answered is whether this trend is going to continue. Oil producing countries are investing in latest technologies for the exploration of oil but till the results turn out to be fruitful, the price will remain at high levels. The world is currently perilously close to utilizing all of its available global oil production capacity, raising the chances of an oil supply crisis with more substantial consequences than seen in three decades. And hence in the future, the worldwide demand for oil will outpace the worldwide supply of oil by a significant margin. As a result, the price of oil will skyrocket further, oil dependant economies will crumble and resource wars will be the norm. (Larry Everest (2003), "Saddam, Oil and Empire", in Counterpunch) References: The Economist (2005) "Oil in troubled waters" Oil Market Report, International Energy Agency (2006) Anthony Dickman and James Holloway, Economics Analysis Department (2004), "Oil Market Developments and Macroeconomic Implications" The Economist (2005), "The Leaders: Oiloholics", Vol 376, Issue 8411; pg 11. Statement of Monetary Policy (2005) James L. Williams, WTRG Economics, Energy Economist Newsletter, "Oil Price History and Analysis" Guinness Atkinson Funds Investment Research Series, "Future of Energy". (Larry Everest (2003), "Saddam, Oil and Empire", in Counterpunch) Read More