The present trend in the Global economy shows that the economies are recovering from the recent downtrend that it witnessed, for example even the Japanese economy, which saw a very bad patch during the recent times, is recovering from the effects. However, the price of crude oil is one important factor that could put an end to the positive trend.
The last few months have seen a constant rise in the price of crude oil from $50 to $43 and now, reaching the dreaded $55 a barrel rate. The price of crude oil has been a matter that has been monitored by several investors and consumers on a regular basis.
How much impact does the price rise of crude oil have on other things and what the reasons behind the price rise would be facts the study of which would be very helpful in solving a lot of issues.
The Price Rise
The price of crude oil has always been increasing and that too real fast. To know more details regarding the trend of this rapid price rise it is important to study the available facts. The available records go to show that the year from August 2003 to August 2004 saw a 38% rise in price of a barrel of crude oil. The crude oil price on the New York Mercantile Exchange as on October 13, 2004 was $53.64 per barrel as against $41.15 on October 1990.
As compared to prices two decades ago it has been on the lower side because a barrel of crude oil costing $40 in the year 1981 should cost approximately $80 in the present times. The prices of crude oil are surging but when compared to the past prices the prices today seem justified.
Reasons for Price Rise
The prime reason for the rise in crude oil prices over a period of the last 30 years is due to a shortage in supply. The main times at which we witnessed a big hike in prices in the past was during the Arab oil embargo in the 1970s, the Iran Iraq war, the invasion of Kuwait by Saddam Hussein.
Today the reasons for rise in prices is more complicated like the proposal of raising the price of a barrel from $21-$28 by the Members of the Organization of Petroleum Exporting Countries (OPEC) as a result of the fall in the dollar rate. Oil prices are expressed in terms of dollars and so any reduction in the value of the dollar is going to reduce the funds flow to the oil producing countries and thus, would have a direct impact on the price of crude oil.
The price of crude oil is above the targeted range and the OPEC countries have reported production at their full capacity for the period of the last 6 months. Some exceptions to this have been countries like Nigeria, Venezuela, Iraq and Indonesia. Venezuela put an end its activities of oil production in the year 2002 due to the political unrest experienced in the country and also as a result of the oil worker strikes.
Venezuela has resumed operations once again but it is noted that it is still not producing to its full capacity. Iraq had to put an end to its production with the beginning of its invasion by the U.S. in the year 2003, although they have resumed production yet the exports have failed to catch up to its earlier figures.
In Nigeria too, the reasons such as oil worker strikes and the ethnic problems and violence has led to the reduction in the oil production by approximately 40%. In Indonesia a fall in foreign investment has led to a fall in production.
If the stability could be got back in these countries then there probably could be an improvement in the situation. There may be other oil producing countries, which may come up and dominate the scenario taking the long run into consideration. Russia from the available evidence is expected to dominate the field and play the role as a major oil supplier.
The production in Russia has gone up by 48% during the last 5 years and there have been major developments with new oil fields and pipelines coming up. The trust, however, in the oil from Russia is however become a shaky issue especially with the happenings at the largest oil company in Russia, Yukos. The Government of Russia government has asked for several billion dollars in the form of back taxes and has imprisoned the founder of Yukos and also freezed the bank accounts of the company.
If the immediate problems in Russia find a solution and countries such as Canada and Mexico make efforts to increase their oil production then the scenario is going to change and we would see a situation were non-OPEC countries increases their production by a whooping 20 million barrels each day by the end of this decade.
Further we would analyze three key factors like speculation, demand and refinery capacity.
The increase in economic activity pushes up the demand for oil. The increase in the demand has been so high that it has come as a major surprise to many a people. The International Energy Agency (IEA) has recently made important revisions for the second quarter to 78.3 million barrels for a day, which is actually 2.2 million barrels more than what was seen in the year 2003.The increase in demand have been touching record highs in the U.S. and China.
The US has reported a great increase in gasoline’s demand. It is seen that drivers in America consume 45% of the total consumption of gasoline in the world. Japan is seen to consume only 5% of the world’s consumption. It is seen that from the period from mid-April to mid-May 2004, the gasoline demand in the US has averaged 9.1 million barrels a day—which is 3.2% more than that recorded in the previous year.
The magnitude of the demand by China has been one factor that has had a big impact on the prices of crude. China itself is known to be the sole reason accounting for one-third of the increase in global consumption of oil (daily). This has also had an impact on air travel and also the sales of automobiles. The rapid industrialization that is seen in the country has created a strain on the infrastructure of the country and also its power generating ability.
China has huge investment in fields like steel, aluminum and the like which is known to be energy intensive sectors. These sectors thus, have a huge demand for inputs from crude oil. The trend of an increase in the number of cars and also the rapid industrialization has more than doubled the oil consumption in China over a period of ten years. Due to the increase in the oil consumption China has gone past Japan and is now the second largest oil consumer in the world second only to the US.
From the year 1983, crude oil futures were being traded on The New York Mercantile Exchange. Over the years the exchange has seen a rapid increase in terms of volume and open interest that is the number of contracts outstanding. The average volume of contracts traded on a monthly basis averaged more than 3.7 million in the year 2003 in comparison to a figure of 37,000 in the year 1983.
Energy futures make it possible for the big consumers of oil and natural gas to hedge and take advantage of the price movements. Energy futures also have proved to be a significant tool for making cross-hedges.
Speculation has become a common feature in the energy futures market. This can be understood from the scenario that shows that the oil futures volume traded is way above the one for hedging only. There are very large risk premiums that are added to such contracts as a result of the terrorist activities that are observed. Further analysis of this would show more details regarding this.
There are a number of techniques that are available for estimating the influence of speculation on energy prices. One of these techniques involves finding out the net position taking the two sides into account – the buyers on the long side (expecting prices to further increase) and the buyers on the short side (with the expectation that prices would fall).
If in this comparison we see a positive net effect then this goes to show that the speculation activities have led to a bubble effect and has resulted in a premium on the oil prices. It was seen that the net position which had touched its peak in the month of March fell which goes to show that lesser number of investors now believe in a further rise in prices and this has also led to a fall in speculation.
The present level is seen to be double of what it was in the year 2003, which was a record that was set during that time.
The second technique to study these trends involves analyzing the open interests and the volumes traded. Figure one depicts a comparison of the volume traded to the open interest that exists. It is seen that the period from 1983-2000 showed a trend where the volume traded was less than the open interest.
There were exceptions to this general rule from the year 1988-1990 when the speculation regarding the Gulf War existed. From the year 2000 it is seen that there has been a change in the trend that was generally seen and that the volume traded has seen a phenomenal increase making it many a times higher that the open interest figures. This is a clear sign of increase in speculation and shows that demand has zoomed past the supply.
From the figure many interesting facts can be obtained. The spike in the volume of contract oil in the year 1990 depicts the uncertainty that prevailed at the time over the supply of oil.
The same situation is now experienced with the Middle East seeing a rise in terrorist activities. The rise in the traded oil futures can be attributed to the rising uncertainty in oil supply. An effect of this would be that the uncertainty would result in volatility in the market and also several kinds of inefficiencies. The volatility would create an opportunity to make profits in the short run and thus the market would become more attractive to speculators.
The uncertainty would lead to a rise in the risk premium that is added to the value or price of the contracts of oil futures. A favorite with the insurgents in Iraq are places like the oil fields, the pipelines and the export terminals. The export terminal located at Basra has witnessed attacks, which have led to the future oil supplies being a matter of grave concern.
The insurance premium to be paid for tankers going to Basra has doubled which has in turn pushed up the crude prices. The bombing of the Southern pipeline has adversely affected exports adversely with exports falling by nearly a million barrels a day.
The Iraq wars have done its damage but the attacks in Saudi Arabia have been even worse leaving a deep wound. Saudi Arabia conducted a number of raids on houses were they suspected terrorists and managed to spoil several plans but after that there was no further progress on the lines. From the month of May 2004 it has been seen that attacks on foreign workers, cases of kidnappings have been on the rise.
These attacks have been a matter of grave concern and many companies have pulled out their workers from here and several others are planning to do so in keeping with the safety of their workers. The pulling out of so many workers can be truly devastating for the Saudi Arabia oil production and can have a great impact on its economy.
Such happenings have increased the fear that these could lead to an adverse effect on the oil production and has in turn led to the rise in oil prices.
Capacity of the Refinery
The factors such as demand and increased speculation activities have led to an increase in the price of crude oil. The price of gasoline has also seen a remarkable rise and this is attributed to the infrastructure problems mainly the capacity of the refinery being insufficient.
The estimation of the IEA is that the global capacity of refinery is 81.2 million barrels a day; this is two million barrels a day more than the present consumption. The refinery capacity is lower than the estimates given by IEA estimates for the estimated fourth quarter demand of 82.4 million barrels a day.
The number of refineries in the United States is about 150 which is about two-thirds of what it was about twenty years back. The overall production capacity has come down from 19.78 million barrels a day in the year 1990 to its present level of 17.68. Many of the small refineries were shut down in the year 1990 because of the low profit margins. The US refineries are observed to be utilizing only about 96% of their capacity.
The current environmental awareness and the strict rules have ensured no new refineries in Europe and the US. The present demand for crude oil being very high and also the high profit margins in this activity have led to several proposals for setting up new refineries in Asia as the environment rules here are still not very strict.
Today the U.S. imports 13% of the domestic gasoline that it needs but it is argued by experts that the future would witness crude oil transferred to the refineries in Asia (from Middle East), which in turn would be shipped to the US.
Reduced capacity and the very strict environmental control laws have made the US import to meet its requirements. The plants in the refineries have been upgraded from time to time; this has resulted in long durations for which the refineries are kept shut and thus decreasing the overall production. It is seen however that many foreign refineries have not witnessed any upgradation.
The imports of gasoline have gone up by about 20% in the month of April 2004 in comparison to the imports a year before in April 2003. This has further led to putting pressure on the US refineries.
Other than these issues the domestic problems also have a major impact on the distribution of gasoline. The environment related laws and emissions standards vary from one state to the other. This also makes the gasoline blends differ from state to state. This difference that exists from one state to the other poses problems for transporting gasoline from one state to another state and thus, this in turn would lead to a rise in the price of gasoline.
The political stability in the OPEC countries may come as a big boon with respect to supply of crude oil from short term point of view, however, from the long run, the non-OPEC countries would be the solution that the world is looking for. The price rise that we witnessed as a result of the hurricane damage to Gulf of Mexico goes to show that when it comes to supply of crude oil we need true stability.
As regards the demand of crude oil, the Americans continue to top the list. There is a recent shift from gas driven SUVs to more fuel-efficient vehicles and hybrid versions, which comes as a welcome change. Whether this is a temporary phase or a change in the attitude only time will tell.
Other big consumers of oil are also taking steps to bring about cuts in their overall demand, for example, China, the second largest consumer has made a declaration regarding taking steps to generate approximately 10% of its requirements through renewable sources of energy by the year 2010.
The plans propagated by China depend on China’s small-scale hydroelectric projects for its success.
The capacity of the oil refinery will continue to be a problem. Since no new refineries are to come up in Europe and the US, the US would ensure that the existing refineries will work at full capacity and the time for maintenance would be reduced. But the real solution for meeting the growing demand would be an increase in the refinery capacity.
Speculation is on the rise. The speculators and also most of the institutional investors are looking forward to the oil sector for making a quick buck. The uncertainty due to the high violence in Saudi Arabia and Iraq is also another factor that is posing problems.
The prices of crude oil are a matter of grave concern to global economies. If the price of oil is going to further go up then it is going to adversely affect the global economies. With violence, political instability and other factors causing a lot of uncertainty the conditions may even deteriorate further, only time will tell.