What Drives the Oil Price? Dr. Behrooz Abdolvand

The Rise And Fall of Oil Prices 1. Over the past 9 years the price of oil has continuously risen. It reached its peak in 2008 at a price of $147. After this, the price fell about 80% to $37 per barrel in only five months. And again is on the rise to round 70$.

Common Explanations for the High Oil Price 1. Demand side arguments Imbalance of supply and demand Increased demand due to emerging markets (China, India) Therefore OPEC has to increase production Peak Oil (demand outweighs supply) Scarce reserves 2. Supply side arguments Hoarding by OECD countries Speculation Dollar devaluation 2. There are a few common explanations for this development. The arguments are twofold: the demand side maintains that there is an imbalance between supply and demand, especially due to the increased demand from emerging markets, such as China and India. Therefore, many maintain that OPEC needs to increase its production. Other common explanations are Peak Oil and the scarcity of reserves. The explanations from the supply side focus on speculation and the dollar devaluation as causes for the record high price of oil.

Increasing Energy Commodity Prices 3. These arguments aside, price increases are occuring not only in the oil market. During the past ten years the prices of not only oil but also of gas and coal increased, all following a similar trend. Taking into account that coal is consumed in the place of its production and therefore is not related to external producers, it becomes clear that this price development is a general one.

Parallel increase of supply and demand Since the last decades we have seen a parallel trend in the incease of supply and demand. There was never a „real“ scarcety of oil on the market.

Parallel development of production and consumption Nowadays we have a permanent spare capacity of oil around 2 bbl/day. Hence, the oil price is not dependent on production and demand alone.

OPEC - Production capacity Additional OPEC has a spare capacity of 3 bbl/ day for market needs. But the oil price is rising.

Increasing Prices – Growing Reserves With rising oil prices from 1990 to 2008 – we experience a growth in oil reserves as well. Therefore, its clear that the oilprice is not only dependent on reserves.

Hoarding can be one of the reasons for price increases The strategic reserves of the United States grew around 3 Billion Barrels from 2001 to now. The United States now hold strategic reserves for more than 2 years instead of 90 days as recommended by the OECD. The amount of these strategic reserves is still growing.

US oil stocks (´000 bbl) US Crude Stocks have reached a historical high.

Number of ships used for oil storage Also the floating storage tankers have reached a high record – but the oil price is rising.

Future Contracts and the Oil Price Apparently the data are right regarding the influence of speculation on the oil price. There is a correlation between the amount of traded future contracts and the price of oil. The amount of future contracts rose from 45,7 million to 121,5 million. During the recent drop in the oil price an amount of 40 billion dollars was withdrawn from the futures market.

Intense correlation between oil price and futures

Oil: Price development and number of traded contracts This trend we can see also after the last oil price decrease.

Trade volume by now 2000 times higher than the production amount

General Trend of Commodity Investments After the bursting of the New Economy bubble, capital was transferred into various commodities, among them crude oil.

This trend is apparent in all natural resoures

S&P GSCI breakdown by sector – the most popular commodity index is energy-dominated

ETF-Securities: Amount of capital held by oil funds

The development of the oil price and the capital influx into the ETFS-Oil-Funds

ETF-Securities: Amount of capital held by oil funds

Historic correlation between the „New Economy“ bubble and the oil bubble

Negative correlation between oil and the USD

Euro/Dollar Exchange Rate and Oil Price Growth 9. Another one of OPEC‘s explanations for high oil prices is the correlation between the devaluation of the dollar and the oil price growth. As you can see, the price of oil rises or falls whenever the Euro/Dollar exchange rate rises or falls. This correlation intensified over the past years.

Illustration of correlation not only in the oil sector, but also commodities in general

Monetary Policy causes Dollar Devaluation 10. The root of this devaluation lies in the monetary policy of the industrialized countries, especially the United States. Since 2001 interest rates were lowered significantly, twice. First from 6,5 to 1 percent from 2001 to 2003 and then from 5,25 percent to 2 percent in 2007 to 2008. In order to counter the impact of the New Economy crisis and the Subprime crises, the amount of money in circulation was increased by the central bank. This led to a massive dollar devaluation.

Historical Process of Dollar Devaluation 11. Indeed, this loss of purchasing power has historic roots. The dollar lost 92 % of its value from 1945, when it became the energy currency, to 2000. From 2001 up to now it again lost a significant amount of its value. This led to a price increase in all commodities, not only in crude oil.

Calculation of cumulative inflation illustrates the current value of the dollar

Nominal and Real Price of Crude 2008 12. This trend can be seen in the increase of inflation per annum. Based on the actual inflation, the real price of crude oil in 1979 would have been 104,91 $ per barrel.

Nominal and Real Price of Crude 2007 Nominal price 2007: ca. 93 $ Nominal price 2007: ca. 93 $ 13. In comparison, based on the level of inflation in 2007, a barrel of crude oil cost 93 dollars in 1979.

Nominal Oil Price 2006 Nominal price 2006: ca. 88 $ Based on the level of inflation in 2006, a barrel of crude in 1979 cost only 88 dollars. The difference between these 88 dollars and 104 dollar amounts to 16 dollars in only three years. This shows the influence of inflation on the price of oil. Going back to 1945, a barrel of crude would have to cost more than 300 dollars now in order to compensate for the loss of purchasing power. This inflation was a reason for the establishment of OPEC.

List Price (Posted Price) From a historical perspective, multinational oil companies dominated the industrial promotion of energy resources in the Middle East and South America up until the 1950’s. Until the early 1970’s, the trade of oil was based on the “Posted Price”, which large mineral oil corporations collectively set; the fees exacted from this “Posted Price” ultimately determined the size of the state budget of the respective countries. As the oil-producing nations increasingly realized how high the profits were from the contributions of the shareholders, they demanded and even higher percentage. The oil corporations, in turn, attempted to decrease the “Posted Price” in order to protect themselves from the consequences of higher demands and to secure their own revenues.

The establisment of OPEC In response, OPEC was founded by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela in 1960, which later expanded to include Algeria, Libya, Nigeria, Indonesia, Qatar, and the United Arab Emirates. OPEC was initially founded in order to unify and coordinate members' petroleum policies and to protect against oil price declines and decreases in oil revenues.

Government Selling Price/ Official Selling Price Consequently, OPEC controlled the oil market and price formation from 1973 until the beginning of the 1980’s. The “Posted Price” was initially replaced by the “Government Selling Price”, which was set by the governments of oil producing states. Later, it was substituted by the “Official Selling Price”, whose price was determined by national oil companies.

Net back In light of the decrease in oil demand during the mid 1980’s, many OPEC countries were guaranteed a fixed margin of payment in order to secure oil sales; this fixed margin would then have to be transferred to the oil refineries. The price risk was assumed by the so-called “Net back” conditions of oil producing states. The producer states provided the refineries with crude oil and received a percentage of the profits derived from the sale of refined oil minus a margin of profit that remained for the refineries.

Price decline as a consequence of „Net Back“ This process, which removes the price risk from the producer and guarantees a margin of profit, led the refineries to increase production levels. This, in turn, tightened competition. Consequently, the price of products declined and the price of crude oil sank to about $10 a barrel within a very short period of time.

Quota regulation/Price increase This induced the OPEC states to introduce production quotas. They curtailed the oil supply and divided the oil output among the member states in order to achieve price stability.

Futures market The oil trade had to re-structure itself. Initially, the trade was handled through spot markets. Later ensued-as a reaction to the oil price fluctuations caused by the limited quota discipline of OPEC-the futures market. The oil futures trade served to limit price risks for oil dealers, but also drew the participation of new groups to the international oil futures market.

Formula pricing Under this system, the price of the delivered petroleum (for instance West Texas Intermediate (WTI), Brent or Dubai-Oman) orients itself toward the average price of futures markets of the previous month. The WTI generally serves as the benchmark for oil that is sold to North America, Brent Oil for the sale to Europe and Africa and Dubai- Oman for petroleum that is sold in the Asian- Pacific market.

Concluding remarks Based on this mechanism, there will surely be attempts made by OPEC to regulate prices. A triangle will remain between the futures markets, the consumers and OPEC in the future. The future oil market will not be a producer market, but rather, a consumer market.

Thank you! Questions?