Crude oil is one of the most important and widely demanded commodity in the world. Wars have been fought over this “black gold”, and as you can imagine there are many variables that contribute to price fluctuations. In 2014 the energy market crashed, which led to a lag in the entire world economy. The world is extremely sensitive to changes in oil prices with out current levels of globalization. No one escaped the repercussions of the oil market crash.
Spot price is the current market price at which oil is sold for. This is directly affected by simple supply and demand you probably slept through in high school economics. Oil production and oil consumption by equipment that use oil as their main source of power are fixed in the short run. It takes time to find new supplies and adjust production and also have consumers adapt to find alternate sources of fuel. Even though much of supply and demand is constrained in the short term, prices can still drastically change in days/weeks/months. It can be affected largely by shocks to either the supply or demand of the product. The main sources of shocks are geopolitical events (most producers are in unstable areas) and weather shocks (hurricanes).
Figure 1. Shows different geopolitical and weather events that have occurred since 1970 plotted with crude oil prices
Lets break down supply a little bit more to really understand the natural and manipulated price fluctuations of crude oil. You may have heard of the organization OPEC (Organization of the Petroleum Exporting Countries) mentioned in the same sentence as oil. This is an organization of countries that act as a single entity in order to control global production and price of oil. The big players for this organization include Saudi Arabia, Ecuador, Nigeria, and much of the Middle East/Africa/South America. These countries work together in order to change prices of oil by either cutting production (increasing prices) and increasing production (decreasing prices). OPEC countries account for about 40% of global crude production, and therefore are considered the “price makers” in the industry. Another method these countries use in order to further control prices is by controlling level of spare capacity. This is defined as the volume of production that can be brought on within 30 days and sustained for at least 90 days, measured in barrels per day. The fact that OPEC countries do not produce at full capacity at all times gives them the Ability to manipulate markets and respond to crises. Price of oil changes in relation to spare capacity level. For example, a hurricane could slow/stop production in the United States southwest. This results in the depletion of spare capacity in Saudi Arabia in order to meet global demand. Oil prices would rise in response to this change in the market. Oil has higher risk premium when spare capacity decreases.
You may be asking where the rest of the 60% of production comes from, since that is in fact a larger market share. This comes from the non-OPEC countries including North America, Russia, and Europe as the biggest players. These countries are not a central organization and make independent decisions about 60% of oil production worldwide. There are also differences in the types of companies that produce the oil. In the United States we have public companies vs. national oil companies for OPEC countries. IOCs (independent oil companies) seek to increase value to investor and make decisions based on economic factors. They have less responsibility than NOCs (national oil companies which have governmental obligation to increase employment, infrastructure, or revenue to the country. Even though these independent players control a majority of the industry they are still considered price takers. The IOCs respond to market price rather than attempting to influence them by managing production. This results in little spare capacity since they produce near full capacity at all times to maximize profits to shareholders. Another generalization about production in non-OPEC countries is they have high finding and production costs vs OPEC national companies with lower costs. This drives new technology and different forms of drilling (offshore) since they are at a disadvantage and need to find a way to be on an even playing field. Lets approach the hurricane problem from another angle:
Less non OPEC production in current quarter due to hurricane (not hitting analyst expectations) → More reliant on OPEC in future → less spare capacity and more price control in future→ upward pressure on oil prices
While supply plays a large part in the price of oil, it is only the piece of the puzzle. There would be no reason to create this stock of inventory if no one was willing to consume it! Here lies the demand aspect of price fluctuations in crude oil prices. We split demand statistics into two categories: OECD and non-OECD. This stands for The Organization for Economic Co-operation and Development, and is an intergovernmental economic organization with 35 member countries, founded in 1960 to stimulate economic progress and world trade. This includes most developed countries in North America and Europe. They provide 53% of world consumption but much less annual growth in consumption. These markets are established and do not have explosive GDP growth that drives growth in commodity consumption. Transportation accounts for much of consumption with high vehicle ownership per capita. Policies have greater effect in the other direction as well, such as high taxes on oil in order to disincentives consumption. These countries are also structurally different than emerging markets, having larger service sectors relative to manufacturing. These countries are predictable in their oil consumption for the near future (until Uber rolls out fleets of flying taxis at least).
Non-OECD countries account for 47% of global consumption, but demand is much less stable/predictable. The big players include world powers China and India, but also the entirety of what we consider the “emerging markets.” This group consists of central and eastern Europe, South America, Africa, and most of Asia not named Russia. While OECD countries experienced declines in demand between 2000 and 2010, these countries saw a 40% increase in consumption. Demand has risen sharply in recent years, and this reflects the rapid economic growth in these countries.
Figure 2. Bar graph showing the yearly change in non-OECD oil consumption plotted against a line graph representing percent change in non-OECD GDP.
***Key point: These developing countries have greater proportion of economy in manufacturing which is a power/oil intensive industry driving increases in demand. It is also projected that all of the net increases in oil consumption in next 25 years come from non OECD countries. ***
There is a very delicate balance between supply, demand, and future expectations of both that drive price fluctuations. Risks are mitigated to some extent through the extensive use of oil inventories. Inventories act as the balancing point between supply and demand. During periods when production exceeds consumption, crude oil and petroleum products can be stored for expected future use. In the economic downturn of late 2008 and early 2009, for example, the unexpected drop in world demand led to record crude oil inventories in the United States and other OECD countries. In contrast, when consumption outstrips current production, supplies can be supplemented by draws on inventories to satisfy the needs of consumers. Given the uncertainty of supply and demand, petroleum inventories are often seen as a precautionary measure. The relationship in inventories gravitates around four approximated variables: the current/future demand/supply of crude oil.
Examples of price action:
- If the market expects future increased demand or decreased supply –> increase futures prices, and therefore inventories will be incentivized to increase supply in order to satisfy the otherwise tightening future balance.
- On the other hand, sharp loss of production or sharp increase in consumption will push up spot prices relative to futures prices and incentivize drawdowns of inventories to meet current demand
- Futures > spot = inventories load up (and wait to sell at higher price)
Many of the risks around changing oil prices are mitigated in the financial markets. This is mainly though the use of futures contracts and other derivative & complex securities. There are many different participants in the commodity markets. Airlines and oil producers have significant exposure to changing prices so they hedge risk by locking in prices through the futures markets and other energy derivatives. On the other sides of those trades are non physical traders. This group includes hedge funds, banks, and commodity traders who do not care about physical product but instead look to make profits off of price changes (short term and long term). Airlines buy futures to lock in price so it doesn’t go higher, and producers sell futures in order to lock in selling price so it doesn’t go lower.
Figure 3. Graph showing the OECD national fuel inventories in reserve against the futures price spread vs spot price at the time.
In conclusion, oil prices are watched by many and understood by few. This article hopefully provided a solid foundation of the oil market complexity. As a society we are becoming more interconnected than ever before. Technology is rapidly changing which could make oil obsolete in the future, but right now is a focal point in our society, and the fulcrum that provides stability to entire “banana republic” countries.