In December 1998, crude oil prices were around
$10 per barrel. Almost ten years later, in July 2008, prices touched $147 and
once again saw a precipitous crash which stopped only at $33 only to rebound
once again to $86 in April 2010. As I write the article, it is $70 in mid-May.
In fact, the last one year has seen crude oil rise 10% but from January 2010,
we are down 15% in May. Now that is what I call volatility! And it only seems
to get better – or worse depending on which side of the petrol-pump you are on.
So, is there a way to predict where it will be after a year or two? A quick
poll among my network threw up answers as varied as $30 to $130. So let’s go
through the reasons which make crude oil prices move and try to figure out the
most likely outcome.
The last
five years have seen choppy waters; it had been a steady climb with a graph
that looked like the rising side of a hill followed by one of the steepest
falls in memory. When asked, many market players are pushing their own agenda. So
as expected, OPEC continues to have a hawkish stance. And why not? They produce
35% of the world’s oil, most of it is exported to the developed and the
developing world and their production costs are in the low single digits.
Therefore, that could just be positioning from a potential beneficiary. One
major factor affecting prices is geopolitical instability; periods of tension
have always resulted in higher prices and it’s hard to tell when the next
stress point will show up. But surely we’re not headed for a more peaceful
world in the foreseeable future, and certainly not in the countries which hold
much of the world’s oil wealth. So oil prices will fluctuate and there will be
spikes on both sides of the median.
Then there
is the ingenious argument that the world is running out of oil. Well, that has
been true for the last 40 years but with a caveat. On an average, the reserve replacement
ratio has been hovering around one i.e. equal recoverable reserves have been
found under the ground than the typical consumption in a year. It may also be
true that spare global capacity (the amount of incremental oil that can be
brought to the market quickly) is a function of technology and there has been
considerable progress on that front. Also, the investment of the last few years
will create enough refining capacity to force fuel prices downwards. One of the
reasons that prices rose sharply in the last decade was due to the refining
bottleneck i.e. low crude oil prices in the 1990s ensured that little investment
was made in refining capacity and the effect was clearly visible when demand
started rising.
The one
real concern today may be that oil fields are ageing, there have been no large
finds in decades and it is estimated that over 75% of the oil produced today
comes from oil fields older than 20 years. So a large oil find by a non-OPEC
country may yet be the best way to inject competition into this industry for
saner oil prices. Then there is the alternative fuels story. There have been no
unqualified successes so far simply because the cost of the alternatives is
more than the cost of crude oil itself. But pushed to the wall, you can be sure
that oil-dependent western economies will definitely find alternative sources
of energy. For them energy equals freedom and lack of energy will equal
anarchy; so the stakes are too high for them to not find an alternative source
when they have to – even if it costs more than crude oil but is within their
control. Also, after the oil-shock of the 70s, per capital oil consumption has
fallen globally as conserving energy and small cars became popular. So
consumers will respond, even if there is a lag.
Arguably, most of the price increase has been based on
speculation and ability to pay rather than transparent fundamentals. The OPEC
is basically a club of 13 countries out to get as much profit as possible in
the shortest possible time. They are simply trying to get their share of the
world’s new found prosperity. There is no shortage of oil and all demand is
being met, comfortably so far.
The prices increases seem to be simply a function of what the
market can take. Of course, history has shown time and again that there is one
level where the relation between demand and price does not remain inelastic and
the consequent de growth leads to a downward spiral i.e. a fall in demand
followed alternatively with a fall in price. Of the 86 million barrels produced
every day, about 30 million barrels are produced by the OPEC member countries.
An increase of $10 per barrel converts to more than $100 billion of additional
income in a year! No wonder they try to talk it up – and this talk is not
cheap! This explains why it is so difficult to convince them to increase
production just so that prices come down. Other large producers like the US
have limited effect on prices because they are net importers.
Another factor to spook crude prices is a strong dollar which is
a scenario unfolding right now even as a US battling recession is faring better
than a Europe, which seems to face a newer and bigger crisis every day. All
these factors make for serious uncertainty and all markets react to uncertainty
by converting it into volatility which is the reason for the violent price
fluctuations in the last few years. Excess volatility has also made it a
paradise for speculation. Purely on demand-supply dynamics, crude oil would
sell for around $20 a barrel i.e. a cost-plus situation without the
gobbledygook of the OPEC, global security scenario and currency play. But the
dominant factor will be the performance of the global economy, which looks
best.
The price of petroleum as quoted in
news generally refers to the spot price per barrel (159 liters) of either
WTI/light crude as traded on the New York Mercantile Exchange (NYMEX) for
delivery at Cushing, Oklahoma, or of Brent as traded on the Intercontinental
Exchange (ICE, into which the International Petroleum Exchange has been
incorporated) for delivery at Sullom Voe. The price of a barrel of oil is
highly dependent on both its grade, determined by factors such as its specific
gravity or API and its sulphur content, and its location. Other important
benchmarks include Dubai, Tapis, and the OPEC basket. The Energy Information
Administration (EIA) uses the imported refiner acquisition cost, the weighted
average cost of all oil imported into the US, as its "world oil price”.
The demand for oil is highly dependent on global macroeconomic conditions.
According to the International Energy Agency, high oil prices generally have a
large negative impact on the global economic growth. The Organization of the
Petroleum Exporting Countries (OPEC) was formed in 1960 to try to counter the
oil company’s cartel, which had been controlling posted prices since the
so-called 1927 Red Line Agreement and 1928 Achnacarry Agreement, and had
achieved a high level of price stability until 1972. The price of oil underwent
a significant decrease after the record peak of US$145 it reached in July 2008.
On December 23, 2008, WTI crude oil spot price fell to US$30.28 a barrel, the
lowest since the financial crisis of 2007–2010 began, and traded at between US$35
a barrel and US$82 a barrel in 2009 On 31 January 2011, the Brent price hit
$100 a barrel for the first time since October 2008, on concerns about the
political unrest in Egypt
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