Oil Demand And Supply And Volatility Economics Essay

The introduction of the internal combustion engine (engine of cars) provided a demand for petroleum products that has sustained the industry to this day. Since then scientists discovered many different products from oil that are important many industries and manufacturers. Crude oil market is the largest commodity market in the world today. Throughout the eras of industrialization, in different parts of the world, demand for oil has always increased. In fact today it is seen as impossible to stop increasing demand. A first indicator of the economic growth is considered rapidly increasing oil demand or consumption.

Oil demand comes mostly from developed and fast growing developing countries like USA, EU

countries, Japan, China and India.

Between 1950 and 1972 the world oil industry grew at a rate of increase of 10% per year.

During that time period, the world produced over 2.4 billion new motor vehicles, half of which in the United States.

In 1950s the global demand for oil was 11 million barrels per day (mb/d). The number increased to 57

mb/d in 1970s and to a little more than 80 mb/d currently. The U.S.A consumes 20.7 mb/d.

World demand has recently grown very rapidly since the economies of China (6.5 mb/d) and India (2.3

mb/d) have developed and growth has increased 10 per cent annually. Still United States remains the largest consumer.

China’s oil consumption has grown by 8% yearly since 2002, doubling from 1996-2006. India’s oil imports are expected to become three times from 2005 levels by 2020, rising to 5mb/d.

The US consumption includes four major sectors: transportation, electricity generation, industrial and residential/commercial. Transportation accounts for almost 70% of all US oil consumption, of which two thirds is motor gasoline.

The overall world crude oil demand grew an average of 1.76% per year from 1994 to

2005, with a high of 3.4% in 2003-2004 and is projected to increase 37% over 2008 levels by 2030 (118

million barrels per day from 86 million barrels), the largest part of increase in demand will come from the transportation sector.

Supply:

Supply of oil is crucial, when we look at its role everyday life. Petroleum usage in industries originated in Europe and USA. First oil wells were drilled in Europe, Russia and USA. However European countries were never big oil producers till hydrocarbon reserves were discovered in North Sea during the1970s.

Earlier kerosene was driver of the petroleum industry; however a big production need became apparent

after the Fords method of automobile production made it possible to buy cars for many ordinary people.

There have been three supply shocks in the recent history.

1973 Arab oil embargo: The Arab-Israeli Conflict caused a series of political and economic crises. In response to Western support of Israel, the Arab countries of OPEC placed an embargo on oil supplies to the United States on October 16th, 1973.

1979 Iranian revolution: Khomeini who is the religious leader came to power after protesters overthrew Shah, monarch of Iran. During that time Iran was producing 6 mb/d, which reduced to almost half.

1991 Gulf war and Soviet Union collapse: Saddam Hussein invaded Kuwait. Big oil producers, created crisis of supply but for a shorter time than in previous one. Soviet Union was one of the biggest producers collapsed and so it too decreased supply.

The five biggest American companies created an oligopoly in union with the three European firms. Smaller companies also entered the market but they never competed the scope of the pioneer companies. The oligopoly made up legal and business systems for extracting oil and controlling supply. But the situation did not persist. Huge profits hindered the interests of reserve owner countries. This started to create a lot of agitation among people.

In response to the growing industry, the producing countries formed the Organization of Petroleum Exporting Countries (OPEC) to oppose them. Its aim was to change decision taking centers from west to the resource owner’s territory. No real country or organization today effectively influences or controls supply as did “Seven Sisters”.

What explains historical oil price volatility?

Most experts say that increased crude oil markets and price volatility can be due to unanticipated

economic developments. Chinese and Indian unforeseen heave energy demand and the declining

weighted value of the U.S dollar can be recent examples. From the figure below it is obvious that first oil

shock was the beginning of the era of the price instability that made world economic growth slower.

Throughout the history many factors caused price instability but recent frequent volatility is something

that world never experienced. We can say that there are two kinds, economic and noneconomic reasons of

increased oil price volatility.

Some of the economic causes are economic growth followed by high growth of demand for oil in

developing countries was not offset by sufficient supply, under investment to new prospective projects

caused by resource nationalism, recent skyrocketed price of exploration technology, maturing old oil

wells, depreciation of dollar value against world currencies.

Short term big price fluctuations are mainly affected by news of US economic performance and

petroleum and gasoline inventory data.

Long term volatility is affected by more fundamental demand and supply forecasts and long term world

economic performance.

Noneconomic factors are mostly politically motivated. For example countries with big oil reserves do not

reveal real oil data for investors, so they could be sure of profitability of their investment projects.

Countries manipulate oil data for the benefit of their political influence and consider it national security

matter. This uncertainty keeps most of the investors reluctant from investing in big perspective projects,

which could secure steady supply.

Instability in the regions of oil producing countries caused by wars for resource control and week

protection of investor’s rights in resource abundant countries caused by different political uncertainties

also noneconomic reasons.

Political games were so intensive last decades that investments to new projects, which provides steady

supply, were totally ignored and as a result so called “spare capacity”3 of oil producers disappeared.

International Energy Agency, Europe’s energy agency, was created to protect western importers interests,

accuse OPEC for not pumping enough oil to meet the demand, which causes price volatility. But OPEC

mainly brings problem of not enough refinery capacity of the world and says that it can increase

production any time but it will not calm down the instability in the markets.

There are many reasons for price instability but in the long run, more than one year period, price is

affected by estimations of world economic performance. As historical data shows that in recessions

period price of oil drops and vice versa. For example during the last quarter of 2008 we witnessed

remarkable drop in oil price from highest 147$ per barrel to lowest 45$ a barrel in world markets, mainly

due to global economic crisis and forecasts of very low demand for 2009.

This creates another dangerous circumstance as low prices can make investment in new oil projects not

profitable as prices fell below the marginal cost of production. Later when world will recover from crisis,

there can be less supply than demanded again and it can contribute for future high price volatility again.

Main Factors behind Current Oil Prices

U.S. Dollar and Crude Oil

The dollar and oil tend to move in opposite directions. This is partly to be expected if the price of oil is in

US dollars. If dollars depreciate then commodities priced in dollars will tend to rise. The International

Monetary Fund (IMF) has identified three channels through which a change in the value of the dollar can

affect a broad range of commodity prices, including the price of oil. A change in the value of the dollar

can affect commodity prices through:

1) Purchasing power and cost channels;

2) Asset channels in which changes in the value of the dollar affect the return on dollar-denominated

financial assets;

3) A combination of effects, including changes in monetary policy.

As a result of these three effects, the IMF also estimates that among various commodities, the linkage

between changes in the value of the dollar and changes in commodity prices is especially strong for oil

and gold, because they are more suitable as a “store of value,” or as a hedge against inflation.

Another consideration is that the value of the U.S. dollar is falling. It was after a long period of strength

Which was due to a flight to quality and security as investors perceived that US was stronger and would solve the financial and economic challenges sooner than other countries. On research, it was found that there was largely an inverse relation between the US dollar value and oil prices.

During most of 2000-2002, the value of the U.S. dollar was above 100 so the oil prices were weak (in the $20s). As the dollar started to fall, oil pri ces began to climb. The dollar fell to about 80 at the end of 2004 and oil prices got stronger. During 2005-2006 the dollar rose in value while crude oil prices also climbed higher – this is a period when there was a direct relation as opposite to the normal pattern.

In 2007, the dollar’s value began to decline falling to the 70 range and the crude oil prices rose. The bottom in the value of the dollar was coincident with the $147 peak in oil prices in July 2008. From that point forward, the dollar stabilized and began to rise in value.

As the value of dollar rose, crude oil prices along with the prices of almost all commodities fell. Now we can observe the inverse of that pattern. It is because the U.S. dollar has been weakening as global investors become concerned about the impact of the magnitude of money being injected into the U.S. banking system and the huge increase in federal government spending due to the economic stimulus bills.

Organization of the Petroleum Exporting Countries (OPEC)

The Organization of the Petroleum Exporting Countries is a cartel of twelve countries made up of

Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab

Emirates, and Venezuela. Principal goal of OPEC is the determination of the best means for safeguarding

the cartel’s interests, individually and collectively. OPEC also pursues ways and means of ensuring the

stabilization of prices in international oil markets with a view to eliminating harmful and unnecessary

fluctuations; giving due regard at all times to the interests of the producing nations and to the necessity of

securing a steady income to the producing countries; an efficient and regular supply of petroleum to

consuming nations, and a fair return on their capital to those investing in the petroleum industry.

OPEC decisions have had considerable influence on international oil prices. For example, in the 1973

energy crisis OPEC refused to ship oil to western countries that had supported Israel in the Yom Kippur

War, which they fought against Egypt and Syria. This refusal caused a fourfold increase in the price of

oil, which lasted five months, starting on October 17, 1973, and ending on March 18, 1974. OPEC nations

then agreed, on January 7, 1975, to raise crude oil prices by 10%.

Overall, the evidence suggests that OPEC did act as a cartel, when it adopted output rationing in order to

maintain price.

Global strategic petroleum reserves

Global strategic petroleum reserves (“GSPR”) means the crude oil inventories that is held by the government of a particular country and private industry, for the purpose of providing economic and national security during an energy crisis. According to the United States Energy Information administration, approximately 4.1 billion barrels of oil are held in strategic reserves, of which 1.4 billion is government controlled. Presently the US Strategic Petroleum Reserve is one of the largest strategic reserves. Other non-IEA countries have begun to create their own strategic petroleum reserves where China is the largest of these new reserves. Current consumption levels are neighboring 0.1 billion barrels per day. It is suggested by some peak oil analyst that in the case of a dramatic worldwide drop in oil field output the strategic petroleum reserves may not last for more than a few months.

Russian Supply Factor

In 2007, Russia’s real GDP grew approximately 8.1 percent, making it the country’s seventh consecutive

year of economic expansion. The country’s economic growth during the 2000-2007 period was primarily

driven by energy exports, given the increase in Russian oil production and relatively high world oil prices

during the time period. Russia’s economy is heavily dependent on oil and natural gas exports. According

to IMF and World Bank estimates, the oil and gas sector generated more than 60 percent of Russia’s

export revenues, and accounted for 30 percent of all foreign direct investment (FDI) in the country. Over

70 percent of Russian crude oil production is exported, while the remaining 30 percent is refined locally.

Crude oil exports via pipeline fall under the exclusive jurisdiction of Russia’s state-owned pipeline

monopoly, Transneft. Oil price fluctuations are a significant concern for the Russian economy, since it

funded a significant portion of the economic boom in Russia. In order to cope with price volatility, the

government established a stabilization fund in 2004. By the end of 2007, the fund was expected to be

worth $158 billion, or about 12 percent of the country’s nominal GDP.

When oil prices increase rapidly, Russia’s economy initially flourishes. According to Yulia Tseplayeva,

the chief economist for Merrill Lynch in Moscow, for each $1 increase in the price of oil, Russia’s

government budget earns about $1.7 billion a year. However, in Russian history, the two periods of most intensive economic change were preceded by long slumps in oil prices. Its dip from an 8 percent growth in 2008 to a 6.5 percent contraction in 2009 is considered the “most extreme of any major economy in the global slowdown”.

Falling oil prices are particularly bad for Russia. A large part of the country’s GDP comes from exporting

its vast supply of crude oil and gas. Falling prices of oil may have other sever consequences for Russia,

including a possible devaluation of the ruble and a severe drop in living standards. The decline in oil

prices from $147 in July 2007 to below $50 today blew a large hole in the government’s budget

calculations. It is now facing a $150 billion shortfall in its spending plans and so far is has cut

expenditures in 2009.

Russian crude oil is mainly sold to markets in Europe and the U.S. Both countries were hit hard by the

recession, government taxation and substitution policies to reduce oil consumption. This has made Russia expand its oil production to Asia-Pacific, where energy demand is increasing rapidly. Also, the proximity to large emerging economies such as China, South Korea and Japan make Russian crude oil prized for its quality and trade efficiency to those growing markets.

Chinese Demand effect

China is the world’s most populated country. It has a very rapidly growing economy. In 2008, China’s real GDP is estimated about 9%, while the country has registered average growth of 10% between 2000 and 2008. Most analysts have predicted a growth of less than the government’s target of 8% for 2009 as a whole. However, the second quarter 2009 grew at 7.9% year over year.

In November 2008, China introduced a 4-trillion Yuan ($586 billion) economic stimulus package which is focused on boosting China’s domestic consumption and fixed asset investment, improving industry value chains and energy conservation in order to decrease its dependence on an export driven economy.

Analysts anticipate that the fiscal stimulus will translate into economic development in the second half of 2009 and 2010. It may also generate a moderate increase of domestic consumption and demand for energy commodities.

Despite the economic slowdown in the past year, China’s energy demand remains high. China has emerged from a net oil exporter in the early 1990s to the world’s third largest net oil importer in 2006.

Coal supported the majority (70%) of China’s total energy consumption requirements in 2006.

Oil was the second-largest source (20%) of the country’s total energy consumption.

In 2008, China consumed an estimated 7.8 mb/d of. This makes it the second-largest oil consumer in the world after the United States. In 2008, China’s net oil imports were 3.9 million bbl/d, making it the third-largest net oil importer in the world after the United States and Japan. According to EIA ‘s forecasts China’s oil consumption will continue to grow during 2009-2010, with oil demand reaching 8.2 million bbl/d in 2010.

Biofuels

Biofuels are produced from living organisms or from metabolic by-products (organic or food waste

products). In order to be considered a biofuel the fuel must contain over 80 percent renewable materials.

A recent publication by the European Union highlighted the potential for waste-derived bioenergy to

contribute to the reduction of global warming. The report concluded that the equivalent of 19 million tons of oil is available from biomass by 2020, 46% from bio-wastes: municipal solid waste (MSW),

agricultural residues, farm waste and other biodegradable waste streams.

Ethanol can be used in petrol engines as a replacement for gasoline; it can be mixed with gasoline to any

percentage. Most existing automobile petrol engines can run on blends of up to 15% bioethanol with

petroleum/gasoline. Ethanol has a smaller energy density than gasoline, which means it takes more fuel

(volume and mass) to produce the same amount of work. An advantage of ethanol is that is has a higher

octane rating than ethanol-free gasoline available at roadside gas stations which allows an increase of an engine’s compression ratio for increased thermal efficiency. In high altitude (thin air) locations, some

states mandate a mix of gasoline and ethanol as a winter oxidizer to reduce atmospheric pollution

emissions.

Global biofuels production for 2009 has been revised up by about 20 kb/d, based on stronger-than

expected 2Q09 output from US ethanol and European biofuels, which offset weaker Brazilian ethanol

expectations. Our estimate for 2010 global production has also risen, by about 15 kb/d. US ethanol

production rose to 670 kb/d in May, up from 640 kb/d in April. Since mid-June, corn prices have trended

downwards, aided by a favorable US Department of Agriculture acreage report and good weather. As a

result, US ethanol margins rose to 2009 highs and we see rising production continuing through 3Q09.

Though utilization rates and margins remained weak in Europe, stronger-than-expected European

biodiesel and ethanol production reported in 2Q09 has prompted an upward revision to European supplies by 15 kb/d for 2009 as a whole.

The production situation has become less optimistic in Brazil, by contrast. Feedstock costs have risen

significantly as sugar prices soared past the 20 US cents/pound mark, driven by drought in India and

excess rain in Brazil’s Centre-South. The high sugar prices incentivize sugar production versus ethanol

and the weather conditions will likely hurt overall sugar yields. IEA revised down our 2H09 production

estimate by only 5-10 kb/d with the start-up of new mills in July providing some offset. Still, production

risks lie to the downside given the combination of weather, sugar prices and the continued negative

impact of the credit crunch on production operations.

Refining Technology and Equipment: A More Important Role in a

Refiner’s Future

Although the known oil reserves in the world are approximately 1.2 trillion barrels, experts estimate that

there are 4.6 trillion barrels of heavy and unconventional oil reserves. At current U.S. consumption rates,

10 to 15 percent of these hard-to-refine oil reserves would last 70 years. As the quantity of “light” crude

declines, oil companies like Chevron have started investing in new refining technology that can convert

oil with lower hydrocarbon levels, known as “heavy” crude, into light, clear gasoline.

When the price of light, sweet crude rose to $147 per barrel in July 2008, many of the Oil Majors began

investing in equipment capable of producing and refining relatively-cheaper heavy crude oil. However,

investments in equipment designed to process heavy crude are expensive, and the cost-benefit ratio

depends on the price differential between light and heavy crude. If the price of light crude rises,

companies with substantial cash on hand will be able to upgrade or alter their refineries in order to extract

more valuable, light refined products per barrel of low-valued heavy crude. Companies with these

capabilities include Exxon Mobil (XOM), Chevron Corporation, British Petroleum, Valero Energy, and

Royal Dutch Shell.

Oil prices and equity market

Crude oil is a very integral part of the economy. Crude oil prices can affect companies, sectors, and even

the whole economy to a great extent. The sudden rise in crude prices was the best example in recent

times. It affected many companies, sectors and nations, positively and adversely. Following are a few

factors pertaining to Crude oil which have a direct or indirect impact on the bottom line of companies,

thus eventually affecting their share prices on the bourses.

Input costs: Input costs have a direct impact on the profits of a company. An increase in the input costs

affects the bottom line of the company negatively, while a reduction in them will have a positive effect on

the earnings of the company.

Effects on alternatives: This is when a rise in the price of one commodity leads to a rise in price of

another commodity. This happens generally in cases where the second commodity is an alternative to the

other. For instance, oil and natural gas can be used as an alternate to each other, as fuel. So if the price of

oil moves up, prices of natural gas will eventually follow, as there will be a shift from oil to natural gas,

thus creating a demand for the latter.

The effect of Government control: Generally in a crude oil price upswing, companies producing or

selling that oil make huge profits. But there may by stray cases where a rise in the price of a oil may

negatively impact the profits of the company marketing it, due to Government controls on the selling

price. The oil marketing companies such as HPCL, BPCL and IOC are the best examples for this. These

companies do well when the oil prices are down and underperform when the prices spiral.

Conclusion

Short Term Prediction

The deep economic recession that has spread worldwide in the past year has taken a severe toll on oil

demand. Green shoots of economic recovery is clearly seen but the demand is not picking up accordingly.

However, despite the improvement of some economic indicators in few country, the most can be said is

that the global economy may be stabilizing – but even if this is confirmed, it remains far from evident that

growth will resume strongly before the next year.

Crude oil prices are currently hovering around $60 to $70, bouncing back from a low of $34 in February.

Considering that supply seems ample and demand is weak, the fact that oil is going up looks kind of

weird. But those factors are being overwhelmed by a huge sigh of relief that we’re not going to have the

Great Depression.

According to IEA, world oil demand would grow at an average annual rate of 0.6%, or 540,000 bpd,

annually over the 2008 to 2014 period, reaching 89 million barrels a day by 2014.

In the short term it looks to be fluctuating around $70 to $80, basically due to the strong demand from

developing countries like India and China. Weak dollar also give support to the high oil prices. The upper

limit will be kept in tab with the continuous supply from non OPEC countries like Russia.

Long Term Prediction

While the short-term outlook for oil remains murky, the long-term outlook for crude is still strong, due to

the weakness of the U.S. dollar and the probability that demand will eventually return.

In fact, the IEA estimates that oil demand will strengthen in India and Saudi Arabia this year, despite a

3% decline in global consumption.

And China, which has been using low commodities prices to stock up on resources, plans to increase

strategic crude oil reserves by 160% to 270 million barrels during the next five years. According to

China’s National Energy Administration, Nikkei English News said that Beijing would spend $4.39

billion (30 billion Yuan) on stockpiling facilities with a capacity to hold 169 million barrels of crude oil.

And with the expansive monetary policy being employed by the U.S. Federal Reserve, the value of the

dollar seems destined to retest the lows it reached in 2008.

With the current improvement in economy the oil could be around $120 by 2014. But the aggressive

investment in development in alternate fuel can spoil the party. Also the improvement in exploring

technology would be a interesting watch when the production cost become relatively low.