Oil prices fluctuate. As with any commodity, price is determined by the interaction between supply and demand. Producers and consumers rely on prices to function as accurate signals as they adjust their supply and consumption. But oil is the most widely-traded commodity and fluctuating prices profoundly affect national economies. To gaurd against these fluctuations, many businesses take advantage of the futures market to safeguard against movement in the price of oil. Then oil speculators come into play. In this article, Petronomist’s economist will address not only how underlying theory of supply and demand affects prices, but also how the futures contract dominates the factors affecting price.
1. SUPPLY SIDE
The oil supply curve can shift position. If the supply curve shifts to the right (from Supply 1 to Supply 2), this is an increase in oil supply. If the supply curve shifts to the left (from Supply 2 to Supply 1), this is a decrease in supply which implies that less will be supplied at each price.
Bad weather affects oil supply. Hurricane Katrina in 2005 caused severe damage to U.S. refineries along the coast and production capacity in the Gulf of Mexico. Oil prices briefly spiked to above $70 per barrel before dropping. Gasoline prices in cities across the United States soared by as much as 40 cents a gallon during the havoc and its aftermath.
President Bush decided to release 30 million gallons from the country’s Strategic Petroleum Reserve (SPR) and brought the price of oil back down. These days, it has become part of the “conventional wisdom” of oil analyst that hurricanes in the Gulf are associated with higher gas prices.
Improved technologies including offshore technology, enhanced oil recovery (EOR), and unconventional oils (oil sand, shale oil) also allow oil companies to increase supply. EOR could potentially double the amount of oil we can get out of the earth—taking it from the current one-third extraction level and up to two-thirds of the original oil in each reservoir. Hence, improved technologies add incremental proven oil reserves in the future and likely cushion the decline in oil production after world output peaks.
2. DEMAND SIDE
An oil demand curve shows a relationship between oil price and quantity of oil consumers are willing to buy. The basic law of demand is that as the price of oil price rises, oil consumers will response by decreasing consumption. On the other hand, as oil prices decreases and supply is abundant, oil consumers will responsd by increasing consumption. The rule of thumb is very simple: the cheaper oil becomes the more consumers will purchase.
The industrialized countries are the largest consumers of oil. The economies of the member countries of the Organization for Economic Cooperation and Development (OECD), for instance, account for almost 2/3 of worldwide daily oil consumption. Regionally, the largest consuming area remains North America (dominated by the United States), followed by Asia, Europe, and then the other regions.
In the spring and summer of 2008, oil prices rose to over $145 barrel. One of the main reasons was due to the fact that oil suppliers were unable to convince buyers that they would be able to properly deliver oil. Even though there was no disruption of oil supply, the perception that there would be a disruption was enough to stimulate future trading frenzy which, in turn, artificially jacked up the price of crude.
Economists sense a correlation between the growth in future trading and oil prices. They argue that future trading is driving up commodity prices and adding to oil price volatility. Some believe that at least $27 of crude prices is a result from speculation rather than market fundamentals of supply and demand. In October 2011, the top U.S. derivatives regulators voted 3 to 2 to curb trading in oil, wheat, gold and other commodities to contain such price volatility.
In conclusion, oil price is affected by the interaction of three different forces: supply, demand, and speculation on futures trading. Stemming from a combination of and interplay between various dynamic factors, price is very difficult to predict. But with high certainty, I can say that the fluctuation of oil prices affects the global economy. If oil prices keep gaining, it might damage consumption and growth, which, in turn, would have a stifling effect on prices.
Darmawan Prasodjo, PhD – Petronomist.com