-->

Tuesday, February 16, 2016

How is Oil Price Really Determined?

Throughout the history, oil prices have had a roller-coaster ride and the trends do not make sense all the time. The current downturn has once again brought into focus the complex dynamics behind this crucial commodity. This article covers the very starting point in this story – the determinants of oil price. The rate of crude oil is impacted by the demand-supply dynamics, but contrary to popular belief, it is primarily set by the derivatives market.

Demand and Supply
The availability of oil in the global market vis-à-vis the current and future requirement, influences the broad market sentiments. Following are some of the key factors:
  • Economic cycles. When the economic situation is volatile, commodity prices rise in general because they offer better security than holding cash. Future uncertainly increases speculative activity in oil futures, leading to a disproportionate price rally.  This happened during the subprime crisis when Brent reached its all-time peak of $145 in July 2008.On the other hand, when the pace of growth slows the overall market activity takes a plunge and the demand of oil decreases. Growth in developing nations, such as China, India and Brazil, has been one of the big drivers of new consumption so far. With the slowdown in these high growth economies, Middle East and Europe the demand for crude oil has contracted and is expected to go down further. Currently, Brent Crude is hovering around $32-$35.
  • Political disturbance. Unstable political scene, internal unrest and threat of external aggression usually pushes oil prices upwards. This is particularly the case when key producer or consumer nations are involved. For instance, during the Arab Spring Brent remained highly volatile and gained almost 50%, reaching over $122.

What Is Keeping The Oil Prices Low?

Oil Price Trend Update
 
  • Changes in supply. It is presently the main reason why oil prices have been in a tailspin since 2014. Unlike in the past when OPEC had the single biggest role on the supply side, other nations have now emerged as important players. The U.S. shale oil production has become a market disrupter, while Iran is likely to ramp up production post removal of its economic sanctions. Nevertheless, OPEC still controls about 40% of oil production. More players, is a trickier situation than what appears at first. No one wants to reduce production for the fear of losing market share and there is also a political angle to it. As a rule of thumb, any new oil discovery reduces prices and any failed exploration supports them. In simple terms, when current or future supply outstrips demand, prices slide and vice versa.
  • Alternative fuel. News from the area of renewable energy sources impacts the oil market. Not only are the Governments looking to reduce their dependency on non-renewable resources, but the consumers are also increasingly adopting environment friendly options, such as solar energy, on the back of technological advancement and government incentives. Greater acceptance for other forms of fuel or development of more energy efficient equipment will indeed reduce the demand for oil in the medium to long term.

Derivatives

The prices we see in the international markets are set on the basis of crude oil futures. Different grades of crude oil are differentiated by their sulfur content. Brent Crude and West Texas Intermediate (WTI), both low sulfur grades, are the two international benchmarks denominated in USD per barrel. The above demand/supply factors influence traders’ views on potential future price movements and the market activity is directed accordingly. However, not all futures trades are hedging transactions. Since the market is largely controlled by big banks and hedge funds, industry watchers believe that the bigger portion of it is speculation.

Brent

Extracted in the North Sea, Brent Crude is used as a pricing base by most countries. It usually leads WTI and OPEC basket price, though the gap has narrowed significantly over years. Before 2005, Brent was traded on the International Petroleum Exchange, London through an open-outcry floor. These days it trades electronically on Intercontinental Exchange (ICE), also in London.

West Texas Intermediate

WTI is the benchmark for U.S. oil prices. Though it is lighter than Brent, it is extracted from land sites and therefore more expensive to transport. WTI is traded on New York Mercantile Exchange (NYMEX) in Manhattan, which converted to electronic trading in 2006.

The Real-World Prices

When the near-term demand shows a potential to increase, the big traders begin taking long (buy) positions in expectation of future price increases, pushing the futures prices higher. As discussed above, these prices are used to set the current rates. Therefore, any expected change in the demand and supply has a magnified impact on the market, which is far from what is warranted. Major institutions and oil producers, including OPEC, have admitted that speculation is playing havoc with oil rates. The hedge funds and banks are happier when volatility increases because that is how they book profits. According to OPEC, “The stability that OPEC and other energy stakeholders seek is of no help to them and severely limits their scope for gain.” An IMF Working Paper, Oil Price Volatility and the Role of Speculation (2014), estimates that speculative demand increase oil volatility by 10-35% in the short-term

Eurion Constellation is a research and consulting firm serving businesses in U.S., Europe and India. The research services have a global reach with focus on industry / market / economic research, financial analysis, equity research, company valuations and report writing. The consulting wing in India focuses on the startup and SME sectors. Please feel free to get in touch for any business requirements. Visit http://www.eurionconstellation.com

No comments:

Post a Comment