IJASCSE Vol 1 Issue 1 2012

Jun. 30

Understanding Shocks of Oil Prices

Gaurav Kumar, 2Suhani Sethi

Abstract The overall situation of crude oil looks like a Cornucopian feast. In spite of discovery of giant new oil fields in Africa & Brazil and new oil sands projects in Canada the supply has increased but the prices too have not cool down as predicted to be. The production of oil in the US has also been increasing and as per the predictions of Department of Energy it would continue to increase over the next two decades. Still, the oil prices have been sharply volatile in the recent few years. This paper tries to understand the rise or fall in oil prices through science of speculation. I. Introduction

economies. Global economic growth, which was quite impressive during 2004-05, has now slowed down there are extreme chances of double dip recession. However, World oil consumption has been growing @ 5 mb/d or 3% p.a. over this period. This strong demand has remained the key reason for the steady and continuous increase in the price of oil over this period. Although initially production capacity was having enough excess to pace with growing demand, it has declined post 2005. With no more oil being produced, that meant other countries had to decrease their consumption despite strongly growing incomes. The short-run price elasticity of oil demand has never been very high (Hamilton, 2009a). It means that a very large price increase has been necessary to contain demand. Hamilton (2009b, p. 231) provided significant assumptions, which showed how a large shift of the demand curve would have warranted an increase in the price to $142 a barrel in 2008. There may have been other factors also like the return to negative ex post real interest rates in August 2007 and the large flows of investment dollars into commodity futures markets, which added a fire and introduced a speculative bubble in the price of oil. The
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In 2008, on the one hand oil prices reached at record highs in July at $147 per barrel and on the other hand fell sharply then to less than $40 per barrel in October. The Prices once again rose during the next years, and have remained more than $90 a barrel during 2011. These sharp ups and downs are partially caused due to concerns of falling demand and the slowing down of

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contradiction is that in spite of available abundant global oil reserves the price spike of 2008 happened. However, if history is a guide, with abundant oil reserves inflation adjusted trend should favour lower oil prices than the elevated values that occurred in 2008. With the decrease in global demand of late 2008 and 2009, indeed the prices of oil fell to levels consistent with their historical trends. (R. Sahr, 2009)

high demand indicates that demand and so the price are unlikely to ease in the near future.

Oil is among those commodities which are the most heavily traded in the world. The fluctuations in prices affect oil producers and exporters and the countries dependant on oil. The main consumers of oil are the leading industrialised nations i.e. the OECD (Organisation of Economic Cooperation and Development). But demand of oil has been emerging from the developing market economies like India, China, Russia, Brazil etc.

This means that besides demand and supply there are some other factors like the role of OPEC and speculation in oil futures that are rather more important in guiding the oil prices. Lets discuss each of them: II. The demand for Oil The lessening demand, if it happens, may have a negative impact on retail prices, but the continuing consumption increase along with the USs steady and
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In the Short run, it is affected by: Cyclical demand: As oil is essentially used in many industries, there is a strong correlation between the economic growth and oil demand. This implies that as the relation is direct when the economy expands, the demand for oil increases. This can be

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best understood by example of Chinese economy. As the Chinese economy has been growing, demand for oil in energy-intensive sectors has led to a surge. Prices of substitutes: The relative prices of substitutes of oil affect oils demand. In the longer run, if relatively cheaper and reliable substitutes for oil become available, then a shift in demand may be seen towards the emerging substitutes. It may take several years to come through but surely one day the substitutes will affect the market for energy. Climate change The changing climate, specially the winter, in northern hemisphere is fierce, so as the USA and Canadian economies increase their demand for oil, the prices of oils also increase. Market speculation: A speculative demand for oil is the reason for recent spike in oil prices. It is hoped by hedge funds that by the time the contracts get expired, a large profit can be made by them. In the long run, assuming that there would be around 3% annual p.a. global growth over the period from 2010 to 2030, as per the IEA, the global oil
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demand is projected to increase by 2% p.a. It is estimated to be about 120 million barrels per day (mbd). This means that if one go by this estimate only, it could result in an $8 per barrel rise in the price of real oil.

This would shift the demand curve outward causing an excess in demand for oil as shown below in the figure. This increased demand would be met by reduction in stocks. This will shift the stock supply curve leftwards and the movement of economy to point b. This implies an increase in price, and a reduction in inventories. But as the rise in demand is permanent, the price increase is also permanent, and this implies that the expected future price will also rise. This will shift the demand curve once again outwards and so this way cycle goes on.

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III. The supply of oil When the supply of oil at the global level is to be considered a distinction between short-term and longer-term supply is to be made in terms of the international markets. The base for drawing a short run supply curve is fixed use of inputs of capital and given state of production technology. As soon as production gets closer to limits, a limit in short-run exerts on daily oil supply and so the supply becomes rather inelastic in the short run. Barry Commoner stated that The law of diminishing returns is the major reason why US has turned to foreign sources for most of oil. Each barrel of oil drawn causes the next one to be more difficult to obtain. The economic consequence is that it causes the cost to increase continuously. ( Bary Commoner 2009) This implies that assumption for the market supply curve for oil is made as non-linear (the LHS diagram as shown below). The supply in short-run is affected by a series of different factors Profit motive: The decisions taken by OPEC and Non-OPEC countries for production

Spare capacity: How much is the level of spare capacity of production Stocks: How much is current stock (inventories) available to be supplied immediately from the major oil refineries i.e. if stocks are at high level it means that supplies of extra oil can be released onto the market as soon as demand fluctuates External shocks: The external shocks like war or loss of output from rig closures may disrupt oil supplies. In a longer-term, the long run supply is linked to Reserves: how much of proven oil reserves can be depleted the faster the growth in demand, the quicker would be the depletion rate. Exploration: Investment How much spending or investments can be done on exploration, identification and then exploitation of new oil reserves. When oil prices rise and if it is expected for them to stay strong in future, sensibly, it would be wise to invest more resources in exploration of new reserves. Technology: Technological change in extraction of oil. If the oil demand is higher which is matched against an inelastic SRS curve, it invariably drives prices higher as shown in the
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below diagram. With an increase in demand oil stocks fall at the major international refineries and so prices are pushed higher indicating as a signal for suppliers to increase production. However there may be time lags between extra supplies that come on stream and the prices. The demand is also inelastic in terms of price. This implies that an inelastic demand and supply combined helps in explaining some if not all, the volatility in world prices.

IV. The role and impact of the OPEC The OPEC accounts for around 40% of current world supply. This implies that it influences the shape of the direction of oil prices. This is possible for it only when the cartel acts together. Non-OPEC countries also supply the largest part of total supply but OPEC in the past have played a big role in moving the futures markets and the spot price to suit
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their aims. In the late 1990s, a backwardation market was created by OPEC significantly by reducing production, which drove oil prices up from $10 per barrel. It is being estimated that the oil endowment at 1.8 trillion barrels and showed world oil production peaking by 2003 at 26 billion barrels per year. But as the actual production was 1.925 trillion barrels in 2002, it implies that only 150 billion barrels of oil remained to be discovered, and set the peak oil production date at 2010. Given that over 1 trillion barrels of oil have already been produced and 1.34 trillion barrels were in reserve in 2009 (Oil and Gas Journal, 2009), there is no room for new discoveries or reserves. As of 2009, there was no peak in sight due to global oil depletion, and production reached 27 billion barrels per year. ( Campbell & laherrere 1998) However, the important point is that the downward price trend, even in the face of cartel oil-production limits and new high-cost finding and production technology, is among the best indications that oil resources are not being exhausted.

Total Output product as a % ion of total 000 world barrels output daily

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Total World 81088 Oil Production in 2005 OPEC 33836 countries Non-OPEC 35408 Former 11844 Soviet Union V. Oil Futures

100.0%

than present physical prices. (Phillip Verleger 2011) A report in August 2009 found that now about 50% of the U.S. oil futures markets are constituted by non commercial players, while prior 2002 it was mere at an average of 20%. None of this moneymaking would have been possible if supplies were tight. The speculation on this scale magnifies volatility in price. When speculations are made too large to impact the futures market, it upsets the healthy tension between producers & consumers and so adherence of prices result according to fundamentals of market. VI. Conclusion It can thus be concluded that besides some factors and political and economical events also affect oil prices. The ongoing restlessness in the Middle East since the start of 2011, which has driven up prices has added fire to those factors. Looking at that one tends to estimate that oil might reach above USD200 till 2013-14, very well before 2020. VII. References 1.Consumption data from EIA; population data from Economic Research Service, US Campbell,
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41.7% 43.4% 14.8%

The oil inventories are closely followed by investors to gauge demand and supply. But, the hedge funds, corporations, FIIs like pension funds etc are new kind of investors in complicated oil markets. Non-industry oil speculations by them mask the real demand and supply in favour of the demand and supply of oil futures. An example can be of 2011, when speculators own futures six times more on the WTIE. As pointed out, forward prices will rise relative to cash prices if a large number of buyers of forward contracts enter the market. The commodity index funds that invaded the oil futures markets with tens of billions of dollars have, since 2004, singlehandedly turned the market from its normal state of backwardation (where futures prices are lower than present physical prices) to contango (where futures prices are higher

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C. J. and J. H. Laherrere (1998). "The end of cheap oil," Scientific American, March 1998: 78-83. 2.Hamilton,(2009a)Understandin Crude Oil Prices, Energy Journa,l 30: 179-206. 3.Hamilton, (2009b) Causes and Consequences of the Oil Shock of 2007-2008,Brookings Papers on Economic Activity, Spring 2009: 215-261. 4.Jerry Taylor and Peter Van Doren 2011: Oil Speculators Are Your Friends <http:// forbes.com//oil-speculatorsare-you 5.R. Sahr 2009, Oil price data, BP statistical review of world energy, 2008; inflation adjustment<http://oregnostate.e du/cla/facultyreserach/sahr/sahr.htm 6.Steven M. Gorelick Chichester (2010) Oil panic and the global crisis ; predictions and myths; Hoboken, NJ : Wiley-Blackwell, 2010. 7.US Geological Society (2008). "Circum-Arctic Resource Appraisal: Estimates of Undiscovered Oil and Gas North of the Arctic Circle," USGS Fact Sheet 2008-3049; "90 Billion
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Barrels of Oil and 1,670 Trillion Cubic Feet of Natural Gas Assessed in the Arctic," US Geological Society News Release, July 23, 2008.