Market price: demand and supply
Today the PetroCaribe Agreement and Guyana’s oil importation has to be contextualized against the dramatic fall in the global price of oil, which started in mid-2014. Back then the price of crude oil was about US$115 per barrel; presently it is hovering around US$45-55 per barrel. This decline in the price of oil of 60 per cent in about seven months, has been faster and further than any major analyst had forecast. Furthermore, most analysts presently predict the decline will be sustained all this year and perhaps into 2016. This situation dominates international development discussions of the risks of global commodity cycles (as considered in this column, on February 1) and their impact on global financial and equities markets.
Economists urge that the basic starting point for any discussion of price is their famous theorem that, most, if not all of us, have experienced in one form or another. That is, the price of any product traded in a market depends on three factors, namely 1) the demand for the product; 2) the supply of the product; and 3) expectations about the way price will behave in the future. Since this holds true for all markets, therefore all likely explanations of the dramatic fall in global oil prices are traceable to combinations of these three market variables. Having noted that, economists urge that the identification of the drivers behind each of these three variables has to be established.
Readers should observe that this market-based explanation of global oil price behaviour has been challenged. Thus for example, while not rejecting the usefulness of a market explanation of oil price formation, a broader political economy explanation is preferred by some analysts. Others go further and argue that in the special case of the global oil market, geo-strategic considerations tend to override market factors.
Market drivers
On reflection readers would agree that the demand for oil depends on many drivers, including population growth; income per person; the two combined (national income or the more familiar GDP in Guyana); availability of alternate energy supplies; credit terms; energy security concerns; and so on. While the listing given is not exhaustive, enough has been indicated to illustrate that most of these variables can be quantified. Economists would do just that in order to build models or numerical estimates of the demand for oil.
Similarly, it can be noted the supply of oil would depend on a long list of factors, including the cost of producing oil; its profitability at the price for which it can be sold; the fact that different producers would invariably have differing cost structures and therefore a different willingness to supply the market; short term inventories or stocks of oil to cope with increases in demand before supply changes can kick in; oil reserves to meet long term growth in demand; and so on. Like the demand factors all these are quantifiable in order to generate supply models or measurable production functions.
The third market variable is expectations. Expectations affect the behaviour of both demanders and suppliers in the market place. Thus if an oil demander expects prices to fall in the future he/she will adjust purchases to suit, for example by deferring these to later. On the other hand, however, faced with the same situation, each oil supplier would have to assess if it remains profitable, in the light of its cost structure, to be supplying oil to the market place.
I believe the vast majority of readers would not be interested in such formal market based analyses. In the next section therefore, I pursue a broader political economy examination of the dramatic decline in oil prices since the middle of last year, and which has led to an advertised decline of fuel prices at Guyoil pumps of about 30 per cent in the third week of January and the promised quarterly reductions in fuel charges by GPL starting March 1 if the price continues to remain low.
Key determinants
I list below ten key determining factors behind the trajectory of today’s oil prices, in no order of ranking. Comments on each determinant follow
TEN DETERMINANTS:
1) The rapid emergence of ‘fracking’ US shale
2) The recent rapid growth of China as an importer of oil
3) OPEC, the traditional marginal supplier to the global oil market
4) Geo-strategic concerns of major players in the oil market
5) Elasticity or responsiveness of the oil market (demand, supply, and expectations) to price changes
6) Speculation in the oil market
7) Contagion effects on financial and equity markets
8) Global economic growth
9) Performance of alternative energy sources and environmental concerns
10) Probable effects of exploration, discovery, and technology on future oil supplies.
Comments US Fracking (1)
Fracking is a highly controversial technique used in the production of oil from shale deposits. It involves injecting a mixture of water, sand, and chemicals into shale formations to release oil. It has spread rapidly in the USA, thereby increasing its oil output by about 80 per cent since 2007, to reach in excess of 9 million barrels of oil per day nowadays. US fracking is undoubtedly a major contributor to the present supply glut of oil on global markets and the fall in prices. Fracking is presently under serious threat because its current cost of production is estimated to range between US$57 and US$70 per barrel of crude. At oil prices below this cost benchmark, clearly many fracking businesses are in the red and several analysts argue that without their withdrawal from the industry so that global supply dwindles, low prices will continue to prevail as the oversupply of crude oil persists. As a net importer of oil the US expects to derive great benefit from lower oil prices despite the impact on its fracking industry.
China’s performance (2)
China’s economic performance, particularly as the world’s second largest economy, also has an important bearing on the trajectory of oil prices. It is at present the second largest consumer of oil and the largest importer of liquid fuels. Information from the US Energy Information Administration (EIA) shows that with prevailing global uncertainty “over the period 2015-2020 the trajectory of China’ economy will significantly impact oil prices.”
Next week I shall comment on the remaining eight determinants before proceeding to evaluate the PetroCaribe Agreement and Guyana’s oil imports in the columns to follow.
