An Economic Perspective on the World Oil Market Student`s Name

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An Economic Perspective on the World Oil Market
1.0 Introduction
The world oil prices have been known to affect economies of many countries through their influences on cost of production. Global oil supplies continue to decline, with the major exploitable reserves in USA and Canada. Global oil prices have continued to fluctuate with turbulent consequences for different markets. Economists have over time attempted to find n a link between fluctuating oil prices and the wider global economy, coming up with multiple analytical approaches which attempt to explain the effect of oil prices on GDP (Managi, Opaluch, Jin and Grigalunas, 2004). However, studies have failed to show a consistent relationship between macroeconomics and change in price of oil. Several factors continue to affect global oil prices, including the Organization of Petroleum Exporting Countries (OPEC) policies, world oil reserve depletion and political factors among other critical factors (Stuart S, 2007). This paper will look into the World Oil Market from an economic perspective with specific interest in determining the determinants of demand and supply, the empirical evidence of oil price`s relationship with economic growth and the link between oil and other sources of energy.
2.0 Literature Review
This section will review data that has been collected with regard to the oil market. It will explore the history of the global oil demand and supply, the dominant forces in market regulation, the current oil market situation as well as the likely situation in the industry`s future.
2.1 Supply and Demand of Oil
Oil demand and supply has experienced fluctuations similar to that of other commodities. The oil industry demand and supply mechanics, however, are subject to special force not usually experienced in other product sectors. The supply of oil, for instance, is dependent on the current explorative as well as production techniques (Regnier, 2007). It is also reliant on political influence, remaining oil reserves, and regulative policies by various trade groups (such as OPEC and governments). Demand is mainly determined by consumer economy which drives affordability, population growth which affects present market volume and political factors such as wars and embargoes. The table below indicates the Energy Information Administration`s report as well as 2013 projections for global liquid fuels production and consumption.
Source
Supply (million barrels per day)
Demand (million barrels per day)
Year
2010
2011
2012
2013
2010
2011
2012
2013
OPEC
34.94
35.12
36.68
36.40
46.23
45.83
45.39
45.16
Non OPEC
51.87
51.94
52.41
53.67
41.06
42.48
43.67
44.78
Total world
86.82
87.06
89.09
90.07
87.29
88.30
89.05
89.94
(U.S. Energy Information Administration, 2012 b)
A more detailed analysis shows that OPEC members supplied less than their production capacity, leading to a surplus capacity averaging 3 million barrels per day as in the table below.
International Crude Oil and Liquid Fuels
2010
2011
2012
2013
[a ]Weighted by oil consumption.
[b ]Foreign currency per U.S. dollar.
Supply & Consumption
(million barrels per day)
Non-OPEC Production
51.87
51.94
52.41
53.67
OPEC Production
34.94
35.12
36.68
36.40
OPEC Crude Oil Portion
29.77
29.83
31.08
30.59
Total World Production
86.82
87.06
89.09
90.07
OECD Commercial Inventory (end-of-year)
2673
2599
2652
2672
Total OPEC surplus crude oil production capacity
3.99
3.00
2.00
3.10
OECD Consumption
46.23
45.83
45.39
45.16
Non-OECD Consumption
41.06
42.48
43.67
44.78
Total World Consumption
87.29
88.30
89.05
89.94
Primary Assumptions
(percent change from prior year)
World Real Gross Domestic Product[a]
4.6
2.9
2.7
2.5
Real U.S. Dollar Exchange Rate[b]
-1.3
-2.6
3.5
3.6
(U.S. Energy Information Administration, 2012 a)
The information indicates supply that is matched, and usually marginally exceeded by demand. The year 2012 and 2013 are expected to have marginal surpluses on 0.04 and 0.06 respectively. The demand -supply relationship for the oil industry is such that a slight variation of either of the two factors may lead to major fluctuations in price, and numerous compound effects in market conditions (Kilian, 2008).
2.1.1 Supply Shifts Determinants
The global oil supply is determined by several factors, which include the remaining global reserves capacity and exploitability, the available technology, political influence as well as cost inflations (Kilian, 2009).
2.1.1.1 Resource Depletion
The known global oil reserves have continually been depleted since the beginning of oil production. While it is true that a significant number of countries are still discovering oil reserves especially in developing countries, it is true that proven oil reserves are finite. The EIA estimates that the proven world reserves as of 2012 are 1.4 trillion barrels, up from 648.7 million barrels in 1981 (U.S. Energy Information Administration, 2012 b). The ongoing exploitation field are gradually declining, or requiring newer, more expensive, sometimes economically unsound, techniques. An example is the Prudhoe Bay oil and natural gas reserve basin whose initial reserves of 25 billion barrels have been depleted using gravity flow methods until more than half the reserve is recovered. To reach additional oil, more expensive methods such as water flooding are needed. This slows down production and increases costs until viability is exhausted. Decline in resources may lead to a decline in global supply unless other producers increase their production or sinking of new wells (Smith, 2009).
2.1.1.2 Technological Innovation
A significant majority of oil producing fields start with natural (or gravity )flow methods in which oil and gas flow to the surface (or near surface) under internal pressure. The volumes in a new production field are usually highest and continue declining as exploitation proceeds. As wells go deeper, newer exploitation methods are used such as Thermally Enhanced Oil Recovery methods (TOER) and Water-Alternating-Gas (WAG) inject. These methods take time to initiate and are expensive, slowing down or totally stopping the production process in some oil fields.
2.1.1.3 Cost Inflation
Cost inflation can be regarded as a momentary increase in costs of important goods, which has limited or no alternatives such as oil. It could arise if production instantly declines during a supply shock, like in the case of an energy crisis. The oil crisis on 1970 is a fitting example where the Arab members of OPEC and a few other countries reduced their oil supply and increase price per barrel in resistance to US aid of Israel during the Yom Kippur war (Managi et.al, 2004). The almost year long shock increased the world oil prices by a factor of 4 per barrel, affecting the purchasing power of many consumers and lowering GDPs (Sachs, 2008).
2.1.1.4 Political factors
The Arab Oil Embargo of 1973 demonstrated how political influence may affect the demand- supply equilibrium for oil, and the consequent implications for the global oil consumption market (Barsky, 2010). In this embargo, the AOPEC members reduced oil output by 5%, and announced an increase in cost by 70% per barrel. Owing to the inelastic form of oil demand, price increases do not proportionately reduce the demand, and oil prices progressively increased in 1973 from $3 per barrel to $12 per barrel in the world market (Yergin, 2008). OPEC had dominated the oil production scene for many decades, effectively maintaining oil prices high taking advantage of the inelastic relationship of demand and pricing. The organization failed, however, to realize the rise of alternative energy sources, as well as increase in oil production by non-OPEC states (Kilian, 2009). These combined effects have over time reduced OPEC`s political dominance in the oil market significantly, though it still has a major influence (Yergin, 2008). The 1973- 1986 oil embargo will be reviewed in a later section.
2.1.2 Demand Shift Determinants
Demand shift determinants affect the overall demand for oil. It is important to note that demand in the oil industry is largely fixed and does not proportionately rise and fall with change in supply and other factors. However, there are factors that effectively affect the demand curve, which are mainly the median consumer income as well as the overall population growth
(Barsky and Kilian, 2010)
Demand and supply curves can be largely used to explain the highly erratic oil prices in world market. The market situation can be modeled using the equilibrium pairs (p1, q1) and (p2, q2). Perturbation of demand and supply moves equilibrium from p1,q1 to p2,q2. A demand shift caused by population growth, income and other factors is measured by the increase from q1 to q2 while maintaining price constant. q2, however, is not readily measurable, and must be determined using the elasticity of demand. Holding this elasticity constant may generate multiple demand curves, with only one curve passing through any one point. A similar treatment can be done to the supply to generate a series of supply curves which model the equilibrium scenario during shift in supply as caused by supply shift factors such as resource depletion, technology and cost inflation.
Various empirical estimates have produced different elasticity coefficients depending on the place where studies are conducted, the time it is done as well as the method used to do the sampling. Short run estimates of- 0.05 and long run elasticity estimates of -0.30 have normally been observed, and it requires several years for complete price stabilization to be effected (Adelman, 1975). According to The Energy Information Administration (EIA), in 2007 projects price elasticity were using more inelastic curves of 0.02 for short run market variations, and 0.10 in the long run. A long term study of the oil market dynamics show that demand has surpassed the non-OPEC supply, increased by 80% from in three decades, while OPEC and non OPEC production has increased by only 24 percent. OPEC has a control incentive of 70% global reserves, and incorporates 11 out of 15 countries that produce oil, presenting a dominant control over the global oil pricing (Lipsky, 2009). The section below will focus on their effects on oil demand
2.1.2.1 Income
Income is a key determinant of any kind of consumption since consumers are willing to spend only what they have. According to Alderman, the world population`s mean income was expected to increase by a factor of 5 between 1923 and 1975. A 1971 -1997 study on income change and oil demand for five Asian countries reveal a positive correlation
Figure: Income versus Demand for oil for Five Markets between 1971 and 1997
(Hamilton, 2003)
The study assumed that income and price have an effect on a nation`s per capita energy and oil demand. Further, the demand of oil and its pricing were asymmetrically related, meaning that a demand reducing effect of price increase was not necessarily reversible by decrease in price. It is difficult to come up with a deterministic projection of the symmetry or asymmetry of oil demand as a factor of pricing, since, as many studies have shown, demand for oil and pricing have shown both types of behavior in different times. The figure below shows the demand/pricing relationship in the US oil market.
(Dermot et al, 2002)
The relationship is rather chaotic, and is governed by multiple external factors in addition to just demand and supply. There have been periods when demand remained high even though prices were high (such as 1978), and when demand remained low even though prices were low (1997). Coming up with a model that incorporates all market variables to give a reliable projection formula has been difficult, and, at best, just incidental (Kilian, 2009). Per capita income, in addition, is only a single contributor to the oil demands per person. The proliferation of alternative energy sources, for instance and the development of more energy efficient machinery has contributed to decline in oil demand even where incomes per capita are progressive (Regnier, 2007). The widespread use of electricity to run medium to heavy machinery, for instance, may greatly reduce a nation`s dependence on diesel fuel (Ghalayini, 2011). The figure below shows the variation of oil demand and average per capita income in Saudi Arabia between 1971 and 1996. The relationship shows a high degree of asymmetry, with the 1971 and 1996 per capita incomes being comparable, while the 1971 demand was only one third of the 1996 demand.
(Barsky and Kilian, 2010)
2.1.2.2 Population Growth
Population growth has been positive throughout oil production history and has a correlation with world oil consumption. The more the number of consumers, the higher the amount needed. According to Alderman 2000, working with world population growth rates of 2% per year, which is overstated when compared with the World Bank current estimates of 1.2% per year, it is estimated that new reserves must develop at a rate of 2.85% each year to keep up with the growing population and the estimated 7.5% reserve depletion rate each year. According to the United Nations world population growth, the world population may hit the 8 billion mark by 2030, which is double the 1975 estimated population of about 4 million (Ghalayini, 2011). To keep up, the median reserve discovery rate must keep up with population increase, assuming that other factors such as income remain consistent.
Figure: World population growth rate
(Barsky and Kilian, 2010)
2.2 The Relation between Growth Rate and Oil Prices
Barsky and Kilian (2010) asserts that, the volatility of oil prices ( which is taken as the aggregated standard deviation of the yearly change in price for the duration between 1974 – 2007 is 31%, which is higher than the golden era (1874- 1973) volatility of only 20%. This indicates that oil price changes are highly volatile and no directly observable trend between economic and population growth rate and oil prices exist. However, data collected in the US over a three decade oil trade history has shown remarkable consistencies between certain trends on economic and population growth with oil prices (Verleger & Philip, 2008).
2.2.1 The Contribution of the Change of Oil Prices in the GDP
Since the 1970s, there has been interest in determining whether oil price lags sustained over a long period has any effects on GDP. In particular, studies have attempted to determine if extended periods of high oil prices may lead to a recession. Kilian, 2012 asserted that the relationship between oil prices and US GDP is non linear due to two factors: that in modeling the relationship, any oil price increases are significant only if they exceed the previous year`s price, and further, because decreases in oil price do not matter in the formulation. Different approaches or models have shown different level of success in predicting GDP performance based on oil prices (Kilian, 2008). Linear models have shown the least success while the four-quarter ahead forecasts predicted only a third of the 2008/09 global crisis reduction in the US GDP. The three year net oil price increase model also failed to predict the GDP fall during the 2008 crisis. Spot checks on markets have shown some surprising a link, though, between oil price and economic growth (Richard & Armesto, 2003). The figure below shows the GDP-oil price relationship in the two gulf war scenarios in US.
(Kilian, 2008)
The figure shows that periods of high oil price almost always corresponded with reduced economic activity and GDP lag. In the 2002 scenario, all three instances of high economic growth correspond to times when the oil prices were stable. The 1991 gulf war figures, on the other hand, shows high GDP performance in instances where the oil prices were going down. While one cannot rule out GDP growth in times when oil prices were going up (quarter 3, 2002), sharp increments in oil prices almost always were observed to lead to GDP fall.
2.2.2 The Relation between Growth Rate and Oil Prices by Period
The relationship between world GDP growth and oil prices may be studied under different economic periods. The Golden era spanned 1964- 1973, when oil prices were relatively stable and low, and world economy relatively stable and gradually growing. The Arab League upheavals including the embargo happened between 1973 and 1986 during which, period the oil prices rose by up to a factor of four. The period between 1987- 1997 was marked by multiple price fluctuations in the oil market including oil prices. The tables below compare various important variables that have shaped the oil market and world GDP between 1970 -2010. The four periods show significant turns in the curves representing all four parameters in the graphs below.
(Kilian & Vigfusson, 2011)
2.2.2.1 The Golden Era
The period started from the end of Second World War up to 1973 the prices of oil were low and very stable. In addition, they tended to gradually decline. In the same period, the economies of most developed countries experienced robust growth as the period also witnessed relatively few political upheavals in the international scale, as well as few economic recessions. This era was the most favorable time for the oil industry. In addition, most of the initial oil reserves were easy to produce, thus the price per barrel could economically be sustained low. As the years progressed, reserve depletion was becoming a threat, and newer, more expensive technologies had to be used to produce more oil and other oil related products (Stuart, 2007) The oil prices for this period averaged less than $10 per barrel.
2.2.2.2 Political Instability in Middle East (1973-1986)
The Israel- Arab war of Yom Kippur in 1973 started a thirteen year long turmoil for the oil market. The US intervened to aid Israel during the war, a step that led the Arab members of the OPEC plus Syria, Egypt and Tunisia to initiate an embargo against trading petroleum with the US. In addition, the Arab nations participating in the oil embargo demanded that the US stop the Middle East war as a necessary condition for ending the embargo (US Department of State, 2012). The OPEC members decided to increase oil prices by 70% to $5.1 per barrel. In addition, participating members decided to cut oil supply at continuous 5% increments, until all their demands were met. The US would receive no oil from OPEC members, while other countries would receive lowered volumes at increased prices. The inelastic nature of demand and pricing for short time oil deficiencies meant that raising the prices would not decrease demand. For this reason, the prices had to be greatly increased in order to adjust demand to favorable levels. This contributed to a price shock that drove oil prices up by factors of up to five.
During the embargo, the oil prices continued to rise until they hit the $13 per barrel mark. During the same period, the western nations were implementing policies that would curtail their oil dependence from OPEC in readiness for any future outcomes of the same type (Kilian, 2008). Compound effects from the collapse of the financial Stock system in the US due to heightened inflation further worsened the global crisis. The embargo greatly affected the macroeconomic balance in major financial systems. The US was worst hit due to its huge energy demands. The government initiated programs to explore for oil and develop it in many onshore locations (Verleger & Philip, 2008). In the meantime, various local authorities set in place measures to reduce energy consumption, including reduced gasoline and other fuel sales, policies for reduced commercial lighting among others. Oil production by OPEC members had greatly been altered by 1980, partly due to the increased productivity of other countries, and also due to internal division among member states. During 1979 energy crisis, the price of oil had reached a historic $80 per barrel during the climax of the embargo. This exaggerated price lasted for a short while, and then the price began to fall again. In addition, alternative energy sources were quickly taking shape, and represented a significant contribution to national energy sources for most developed nations (Kilian, 2008).
2.2.2.3 Fluctuations in Price (1986-1997)
The oil embargo ended in 1986, with supply to the west resuming to its initial state and prices momentarily reaching the pre-crisis amounts. During the 1986 oil glut, the world cost of oil declined tremendously due to lowered demand after more than a decade of crisis. The previously exaggerated price of $35 per barrel reduced to $10. During the crisis, consumption in major economies including US, Japan and Europe had reduced by 13%, largely owing to consumer adjustment to less energy usage, as well as due to the increased pricing set by OPEC producers. In addition, the US halved its active exploratory measures due to fears that the glut would continue and lead to massive losses in investments.
During the same period, OPEC dominance in the oil market scene had been greatly challenged. Part of the reason for this was its reduced production in an effort to sustain oil prices high, as well as it high pricing policy. Another reason was due to rapid rise in non-OPEC member production. In the 1980,s the US energy requirements had reduced by 18.5% due to energy consumption reduction initiatives, and its total imports were 28% and mainly from Britain, Nigeria, Mexico, Norway and Canada. In the meantime OPEC countries were misjudging the elasticity situation of oil pricing versus demand and supply, wrongly believing that sustained low supply would invariably retain prices high, not withstanding that other non OPEC members were increasing production. In this regard, major OPEC members like Saudi Arabia invested their huge earnings to increase reserves, sometimes in the expense of their national budgets. When the glut struck, partly due to varying ambitions by OPEC members who released high oil volumes for trade to improve their stake, most OPEC countries witnessed drastic reduction in earnings, a situation which led to sharp internal division within the organization. This situation led to tensions that precipitated the Iran-Iraq war on 1990, which again led to a temporary shortage of global oil supply.
The next one decade witnessed several fluctuations in oil prices mostly owing to political disturbances and minor economic crises. The period ended with the 1997 Asia financial crisis which had been in progress since 1993. In the crisis, major stock devaluation due to foreign currently shortages, as well as unbalanced accumulation of debt leading to high debt to GDP ratios for the major Asian economies including Japan, had threatened to collapse the Asian trade and financial systems. The ripples of this imminent collapse negatively affected the oil prices, with many unfavorable price fluctuations.
2.2.2.4 Stability after the Asian Financial Crisis (from 1998-2008)
The International Monetary Fund intervened in the Asian financial crisis and injected $40 billion to stabilize the currencies of Indonesia, Thailand and South Korea, which were most affected by the crisis. This led to a recovery of currency values for the Asian countries affected by the crisis. The price of oil has, in the last one decade assumed a gradual rise with short-lived fluctuations without major lasting effects on major economies. In December 1998, oil prices had stabilized to $30 per barrel and maintained that stability for a period of time, eventually rising to a record $145 per barrel in the wake of global financial crisis of 2008-2009. The reason for this stability was attributable to multiple factors, including the fall of the OPEC initiated embargo and a decline in its role as a monopolistic authority in the oil market.
Secondly, the rapid rise of other producers shifted the balance of control so as to self stabilize every time the demand- supply scenario was upset. British Petroleum observed that as many as 50 countries produce oil, and that two thirds is exported (Verleger & Philip, 2008).The role of alternative sources of energy continued to reduce the world`s reliance on oil, further stabilizing the global oil prices. The period between 1998 and 2001 witnessed a rise in oil prices attributable to OPEC cutbacks in its productivity, gaining a temporary stability at $35 per barrel in 2001, just before the September 11 terrorist attacks on America after which oil prices momentarily dipped below $20 per barrel.
2.2.2.5 The 2008 Financial Crisis Period
The global financial crisis of 2007-2009 had a major effect on oil prices. During this period, oil prices attained an all time high of $140 per barrel. In five months time, in December 2008, the global oil prices fell tremendously to just $40 per barrel, a 3.5 factor decline. The oil price bubble of 2008 was fueled mainly just by speculation, with several front line theorists proposing that the world oil volume was declining. The reasoning behind of this speculation was explained by IMF, s first secretary John Lipsky (Lipsky, 2009).
2.3 The Trade of between the Renewable Energy and Oil
Notable figures in the Arab oil producing countries such as the United Arab Emirates (UAE) president Sheikh Khalifa bin Zayed Al Nahyan, and Saudi-Arabian petroleum minister Ali Al-Naimi have stated that a $70 -$75 per barrel price is a fair price for both consumers and producers, and that future price regulations may be geared towards attainment of this equilibrium price range. The reason for this incentive, they said, is that prices higher than this would negatively affect the world`s economy, and prices lower than that would increase consumption and discourage the alternative renewable energy sector (Ghalayini, 2011). Currently, most major economies are working to achieve a trade-off between oil and renewable energy.
According to EIA, US currently uses 6% renewable energy and efforts are in place to reduce dependence on oil. Petroleum contributes 40 % of US energy consumption. The International Energy Agency states that in order to achieve the global goal of reducing by half CO2 emissions by 2050, nations must work towards doubling their dependence on renewable energy by 2020 (International energy agency, 2012). Currently, the world`s dependence on renewable energy is only
(U.S. Energy Information Administration, 2012 b)
According to BP, the current dominance of oil is 33%, while renewable energy contributes on 1.59%. This implies that world dependence on oil as the major source of energy will continue. Combined, oil, coal and natural gas contribute more than 87%, and the annual increase in reliance on renewable energy alternatives is 2%.
(Kilian & Vigfusson, 2011)
3.0 Conclusion
This study implies that the world oil market structure is still monopolistic, with OPEC holding more than70% proven oil reserves. This means that the few dominant producers are able to sway the market conditions to favor them. In addition, the world`s dependence is still very high, with no foreseeable change from this situation. The dominant factors in oil demand and supply dynamics are political influence, world income patterns and reserve depletion. To a lesser extent, alternative energy sources are a factor in the demand-supply scenario. The study has also shown that while the elastic/inelastic nature of oil prices with demand/supply cannot be readily modeled with any existing formulations, world data for the last 60 years indicate that there exists a long-term negative correlation between global economy and oil prices, and that almost invariably, periods of exaggerated oil prices correspond to economic downturns. The short term price shocks, however, do not in themselves significantly influence economic performance, or the demand for oil (Verleger & Philip, 2008).
The oil market influences the renewable energy market in that when the supply of oil, or its price is too high, there will be a general rise in demand for alternative energy. Renewable energy, however, is still expensive to produce and sustain, which makes oil still dominant in the global energy source (Ghalayini, 2011). The world oil prices are expected to rise steadily in the absence of major political or financial crises, until the renewable energy alternatives catch up during which time the world reserves will have reduced to amounts expensive to produce, or at least more expensive than the alternative energy sources.
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