Demand-supply dynamics at work in oil markets

From $147 per barrel on July 11, 2008, to below $70 now, the fluctuations in oil prices are a reasonable representation of the volatility and uncertainty facing the global economy today. Roger Lowenstein has an excellent exploration in the NYT of the happenings in the oil industry in the lead up to recent dramatic events. The reasons for the volatility predictably appears to be a mixture of speculative interest, declining production and spare capacity, reduced investments, civil and political conflicts, and increased demand from emerging economies.

While speculative interests may have had a role in driving up prices, it may not be a adequate enough explanation for the large volatility. Approximately 500,000 crude-oil futures contracts, representing 500 million barrels, trade on the New York Mercantile Exchange alone each day, whereas the world uses only 86 million barrels of oil daily, and the overwhelmingly major portion of these trades are settled in cash before the contract expires and do not involve taking any physical deliveries. The lack of build up of inventories and the close links with the real economy by way of actual deliveries of these trades, limits the amount by which prices can increase.

Even as oil prices rose this decade, big oil companies — still responding to the price signal of an earlier period — plowed most of their cash flow into dividends and stock repurchases rather than risk it on exploration, and there was a lull in building critically needed refineries. By the middle of this decade, various big oil regions — Mexico, Nigeria, the North Sea, Colombia, Venezuela — were experiencing production declines.

Many older wells are declining in their outputs and merely maintaining the output levels require investments, some thing many producers are not willing to do without the incentive of higher prices. The marginal barrels today are found in remote and costly terrain, like the Canadian tar sands or off the coast of Brazil under 7,000 feet of seawater and more than 10,000 feet of ocean floor.

The expectations of a double squeeze on capacity from declining production and increased demand was enough to set in motion a series of forces that signalled to both producers and consumers and drove up prices. The present decline in oil prices is of significance in so far as the final (medium-term) floor price will determine the viability or otherwise of alternative options like natural gas and renewable energy sources.