The Importance Of Oil Price In Market Economy

The Importance Of Oil Price In Market deliveryOil legal injury has be have it away a fundamental f pieceor of todays market scrimping as it influences financial markets as rise as consumers, corporations and g everywherenments. Oil variance has not only a tremendous impact over the stock markets but also a major influence on the orbicular economy bumpy cover colour is needed for industrial purpose much(prenominal) as power generation, chemical products, transportation etc. In particular proposition crude crude rock vegetable anele colour admit and tack on drive volatility and any upward or downward impairment movements is tracked by any financial market player as it at wiz time influences future lookout station and real growth of exporting and importing countries. Higher egregious vegetable crude colour impairment implies higher(prenominal) bell of nada leading to a slower economic growth, inflationary pressure, asymmetrical results on consumers and pr oducers side and global imbalances. Oil scarceness and increasing regard of emerging market countries have neuterd inunct market as salutary as political un authoritativety leads to an improver in crude volatility.Since 2000, vulgar fossil fossil anoint color has experienced an incredible expenditure rally, despicable from $25 in 2000 to over $144 in July 2008 and getting back new-fangledr December 2008 to $35. These huge damage convinces argon mainly undesired because they ontogeny un trustworthyty and chthonicmine investment in petroleum as well as alternative energy sources. tear down if we argon getting much and more acquainted(predicate) with this impairment uncertainty or at least with oil price volatility, it is necessary to understand the key driver of this commodity in set up to be able to conduct accu regulate studies and to forecast and prevent new gentlemans gentlemanwide market chock there argon mainly two contrasting explanation to oil price behavior. The scratch one is related to the idea that markets are experiencing a structural transformation in oil price bedrock the second one is related to substantial speculation in oil market. The supporters of this second view argue that the massive oil crude price washbowlnot be explained by simple change in market fundamentals but can be rather explained through a market straining caused by speculators.This dissertation depart investigate oil and the oil market players trying to understand the diametrical price de preconditioninants and the interaction of key players it starts with an historical overview of oil price and it successively analyzed oil as a commodity, oil as a financial asset, the role of expectations in the formation of oil price, the industry outlook for the next years, oil derivatives on the financial markets.Oil FundamentalsHistoryOil industry was born in the 1859 in Pennsylvania, United States when Edwin Drake opened the call off printing oil well. T he industry grew slowly during the second half of 1800 when the business pioneer George Bissell together with the banker, James Townsend, established the first oil company Pennsylvania shake off Oil Company. The industry became more and more attractive and in 1870 John D. Rockefeller established the Standard Oil Company. Boosted by the introduction of the internal combustion locomotive engine and by an increasing energy expect caused by the outbreak of World War I, the oil industry became one of the foundations of modern industrial society, ready to scourge coal as the most used and requested energy source.As the chart points out the price of oil remained steady from the beginning of the century until the first energy crisis, risen by less than two percent per year. Spot crude oil price go from $2.83 per barrel of 1973 to $10.41 of 1974. This add-on in price was caused by the oil embargo proclaimed by the OPEC, Organization of Arab Petroleum Exporting countries in response to the U.S. decision to re-supply the Israeli military during the 1973 Arab-Israeli War, fought among Israel and a coalition of Arab states backing Egypt and Syria. The OPEC countries limited their production as well as the shipment of oil cargos to United States and other countries. The embargo led to quadrupled and extremely evaporable oil price and it showed how high was the dependency of western economies from the oil reserves controlled by the OPEC members. Following the first oil crisis, in 1979 took place another piercing rise of oil prices following the Iranian revolution the overthrow of the regime of Shah Reza Pahlavi triggered a strong speculative movements of oil price. The price add-ond from the $14 needed to buy a barrel in 1978 to roughly $30 in 1979 causing a widespread panic and affecting geopolitical forces. Moreover in 1980, Iraqi invaded Iran leading to oil cut production of Iraq and a total stop of Iranian production. All these events strongly influenced oil pr ice and demonst sendd how thoroughgoing(a) supply and demand get overcome from sociopolitical facts.The so-called oil glut of 80s changed again the oil market environment as the price of the black deluxe fell from $35 to $15 in 1986 due to a falling demand, slowed economic activities in industrial countries and an increase in production. The crude oil price fluctuated amongst $15 and $25 until 1999. At the beginning of the new century the oil price increased exponentially and reaching $30 in 2003, it moved to $60 sawbuck in 2005 and floweringed at $148 in 2008. This incredible ride of oil can be explained by diametric factor such as decreasing US Dollar value against other currencies, declining petroleum reserves, speculation, increasing demand from emerging market and OPECs lower than expected increase in production. But later reaching the peak on July, 11th 2008 the price declined consistently falling below $100 on September 2008. Because of the financial crisis world oil d emand fell rapidly and in just a couple of months it touched the lowest point at $34. Until April 2009 oil price fluctuated between $35 and $40 and recovered to roughly $70 in early 2010.Oil as a productPeople are more familiar with refined oil products such as gasoline, diesel, kerosene and heating oil rather than with crude oil. The basic oil refining process is distillation crude oil is heated and oil products card-house off at different temperatures, the lightest at the lowest temperatures and the heaviest at the highest temperatures1. Afterward these products are treated further to chafe finished oil products such as gasoline kerosene etc. Gasoline is commonly used for cars while kerosene is widely developed for airplanes and households light heating. Diesel is widespread as combustible for tracks and agricultural machines while heating oil is mainly used for space heating. Oil this different refined products come from crude oil and even if crude oil is considered as a commo dity, there are several qualities of crude depending mainly on two different chemical gracefulties density and sulphur content. Crude oil is therefore divided into heavy or light consort to the density take and sweet or sour according to the sulphur content. Nonetheless, in financial market, the three most quoted products areWest Texas Intermediate Crude, WTI very high-quality, sweet, light crude widely traded in Nord-AmericaBrent Crude a basket of 15 similar middle-high quality, light, sweet crude oils extracted in the brotherhood SeaDubai Crude light sour crude oil extracted in DubaiEven though West Texas Intermediate Crude has the highest quality, Brent is used to price two thirds of the worlds internationally traded crude oil supplies according to the International Petroleum Exchange (IPE).Oil characteristics ExhaustibilityOne of the leading feature of oil is that oil is a non-renewable resource as once it is consumed, it is no bimestrial available. In particular once ex tracted, oil is consumed quicker that it is naturally produced oil is therefore not replaceable within short time. Another very important feature is that supply of such as product is limited relative to demand.This two characteristics are essential to understand that oil can only be analyzed through dynamics standards and that unlike standards goods, oil provides oil holder a positive premium known as scarcity rent. When demand for crude oil exceeds supply, oil price earns an economic rent due to its scarcity in other words, it worth keeping oil underground waiting for increase in demand not covered by an increase in supply.The framework which is widely widespread regarding non-renewable resources is the Hotelling model first introduces in 1931, the model questioned which is the measurement of resources that should be extracted during a certain time frame in order to maximize the profit of the resource holder? Assuming no extraction be, a risk free measure on investment equal t o r and a certain price per barrel, according to Hotelling model, the optimum extraction quantity is the one that leads the price of oil to grow over time at a take rate r. In other words, the resource holder has two opportunities he can extract oil today or he can leave it underground waiting for a rose in price. Assuming that he decides to extract a certain amount today, he can invest the proceeds at a risk free rate r otherwise, if oil price is expected to grow at a higher rate than r, the resource holder is not incentivized to extract oil. Thus, if all the resource holders behave the similar way, it is highly probably that oil price will increase. Therefore, according to Hotelling models, the optimum extraction is the one in which oil price grows at the rate of interest. This model refers and implies that oil price will increase over time due to oils exhaustibility oil price must increase as fast as it is consumed.Even though Hotellings model is commonly used to predict the s hape of oils trend, one of the most important Hotellings assumption is that the reserves of oil are fixed as can be understood later on in the dissertation, oil reserves calculation is far from universe detailed and exhaustive. Oil is extracted as well as found continuously new reserves become continuously new available resources. Thus, an argument against the Hotelling approach is that it is not possible to evaluate scarcity rent and therefore it is not possible to use models such the Hotelling one which are based on this data.Demand and supply.As for any product, the main drivers influencing oil price are demand and supply. In the coherent term oil price is determined by the match of demand and supply however, due to the peculiarities of oil, it is rattling difficult to predict future price unknown future events, wars, natural events, OPEC decisions on cutting production and demand ginger snap shape different demand-supply equilibriums. opus price and income are demands main drivers, on the supply side it is necessary to take into consideration several factor such as reserves, oil depletion, technologies and oil cartel decisions.Oil SupplyIn January 2010, global oil supply scotchs for 85,8 million position per day, out of which 51,6 has been produced by non-OPEC countries.There are different factors that are needed to take into consideration analyzing crude oil demand. Evaluating the supply is more complicated than evaluating the demand as there are different player involved, OPEC and non-OPEC countries and there is the central issue related to oil reserves level. First of all, exporting countries do not incur in any storages cost for crude oil as they can simply decide to leave oil underground while importing countries, in order to establish a minimum reserve level, need to built storage facilities. In regard to production countries, the most important and influential player is the Organization of the Petroleum Exporting Countries. While non-OPEC cou ntries act competitively, OPEC is a cartel whose aim is to maximize revenues and profits.OPECThe Organization of the Petroleum Exporting Countries (OPEC) is a permanent, intergovernmental organization founded in Baghdad in 1960 and at that time it encompassed 5 countries Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. The founding members were later joined by nine other members Qatar (1961- 2009) Indonesia (1962 2009) Socialist Peoples Libyan Arab Jamahiriya (1962) United Arab Emi place (1967) Algeria (1969) Nigeria (1971) Ecuador (1973) Angola (2007) and Gabon (1975-1994). Since 1965 OPEC headquarters is Vienna. It is interesting to highlight that the declared tutelage of the organization is to coordinate and unify the petroleum policies of member countries and ensure the stabilization of oil markets in order to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers and a fair return on capital to those investing in the petroleum industry2.In order to understand the relevance of the OPEC countries over oil market, it is important to quantifies to what extend are worldwide oil reserves in OPEC territories at the end of 2008, world proven crude oil reserves stood at 1,295,085 million barrels, of which 1,027,085 million barrels, or 79.3 per cent, was in OPEC member countries. In 2008 OPEC countries produced around 33 million barrels per day of crude oil, or 45.9 per cent of the world total output3. Besides owing the largest oil reserves, OPEC countries have the lowest production costs roughly $4.00 per barrel for Saudi Arabia or $ 4.50 for Iran, as compared, for example, with $9.85 for the North Sea and $12.50 for Brazil.4Non-OPEC countriesNon-OPEC countries are generally considered as price taker and even though in the last ex oil price has full-grown consistently and observers would expects a proportional increase in non-OPEC supply, the response of oil producers countries outside OPEC has been weak. There are several factors that are needed to taken into account in order to understand this behavior first of all it is becoming more and more costly to develop oil reserves in this countries and the level of technologies needed to increase or at least maintain changeless the production output is really high and expensive. Moreover, price volatility has increased uncertainty, changing the risk profile of non-OPEC countries they are becoming more sensitive to oil price cycle. Investment are therefore asymmetrical during tremendous increase in oil price, investment are modest, while during a decrease in crude oil price investment rate in exploration or new technologies decrease consistently leading sometimes to underinvestment periods.In order to analyze non-OPEC countries oil supply, it is possible to use a model introduce by Marion King Hubbert in 1956. According to Hubbert model, known also as the Hubbert peak theory, oil production tends to follow a bell-shaped curve which can be div ided in three different phasesthe first one, the pre-peak phase shows a exponential growth in oil productionaround the peak, the production reaches the uttermost production level and the production becomes stagnantin the following phase, the last one, oil production starts a terminal decline due to resource depletion.The peak is reached when half of the oil reserves has been discovered and used in order to draw the bell-shaped curve, it is necessary to organize historical cumulative production, breakthrough rate of new oil deposit and the size of the URR, ultimately recoverable reserves. The main idea of the model is in fact that oil is a finite resources and therefore, when discovery rate is less than the oil consumption rate, oil production starts inexorably to decline with all the related consequences on oil price. The bell curve is move considering both the cumulative production and the remaining volume of oil that will be produced as a percentage of the total oil already pr oduced in past. As a consequence it can be used in order to calculate and forecasts oil production and consequently price forecasts.According to Hubbert, North America reached the peak point in 1960, while in United Kingdom and Norway the maximum has been touched in 1999.The limits of this approach are related to the difficulties to calculate ultimately recoverable reserves improvements in technologies and discoveries of new deposits or higher exploitation of existing deposits are pushing the oil peak to the right. Instead of being static, ultimately recoverable reserve is a dynamic measure underestimation or overestimation of oil reserves as well as higher rate of technological improvements lead to mistakes in calculation of the year in which world will reach the peak oil.Oil reservesA proper forecast of existing oil reserve is a fundamental aspect of oil supply as it is central to Hubbert peak theory. First of all, it is necessary to set up the different type of reserves availabl eProved reserves are crude oil reserves that once calculated, provide at least with a rate of 90% of certainty at least the oil crude amount estimated. This depends on how accurate are the geological researchesUnproven reserves are crude oil reserves similar to proved reserves but for several reasons such as political or contractual are certain for a rate lower of 90%. Therefore unproven reserves are divided into probable reserves which are reserves that are certain for at least 50 % of the amount estimated and possible reserves which are unproven reserves that are certain only for a 10% of the earlier amount estimatedGiven the different definition of oil reserves, it is very important to highlight that there is not a convergence estimation of oil reserves several studies calculated different reserves level according to different study methods and according to the extent of proved and unproved oil definition. Another distortion of oil reserve calculation is due to the fact that exp orting countries are willing to overestimate their reserves because higher are the reserves, higher is the quantity that they can sell or export. Moreover, higher are the reserves declared, higher are the loan that these countries can raise.There is another issue related to the residue between conventional oil and unconventional oil. Unconventional oil refers to the oil extracted using other techniques than the common oil well method such as biofuels, oil shale, oil sands etc.In addition to these, there are reserves of oil that are yet to be discovered but granted the current level of technologies are too difficult to be reached and explored.It is therefore clear that oil reserve calculation is really complicated according to OPEC annual statistical bulletin 2008, world proven crude oil reserve are estimated to be 1,3 trillion barrels out of which 79, 3% are keep under OPEC countries ground5. According to the Oil Gas Journal6, in January 2009, proved world oil reserves were est imated at 1,342 billion barrels-10 billion barrels (about 1 percent) higher than the estimation for 2008 56 percent of the worlds proved oil reserves are in the Middle East while just under 80 percent of the worlds proved reserves are concentrated in eight countries out of which only Canada and Russia are not OPEC members. According to BP Statistical look backward Of World Energy of June 2009 proven reserves accounts for 1258 billion barrels,AGGIUNGIOil DemandIn 2009 the worldwide oil demand fell by 1.4 percent in comparison to 2008 due to the financial crises that invested mainly OECD countries this was the biggest drop since early 1980s. During the previous period, 2003-2007 growth rate in oil demand averaged 2,0% per year, 0,8% faster than during the preceding 5 years and 1,2 % faster than it average since 19807. Around 90% of demand growth during this period came from non-OECD economies. Indeed, OECD demand has been falling year on year since the end of 2005. passing(a) crude o il demand in early 2010 has reached 86.5 million barrels as the last quarter of 2009 has been the first quarter of demand recovery after 5 consecutive quarters of decline.GO ONOil market volatility and elasticityPrice elasticity to crude oil demandThe birth between oil demand and price can be analyzed looking at elasticity of demand elasticity measures the relationship between the change in quantity of oil demand for a given change in oil price. As the chart XX shows, both short term and long term price elasticity of demand are really is low ranging from 0 to -0.6. Furthermore it is clear that short term elasticity of oil demand is even smaller with a range from 0 to -0,1. This means that change in oil price have a very modest impact on long term crude oil demand an even lighter printings on short term oil demand. The difference between short and long term demand reactivity to change in oil price is due to bigger rate of substitution and energy conservation in the long term.What is really important to notice is that oil demand may respond asymmetrical to changes in oil price8 in other words there is a substantional difference of demand elasticity for either an increase in price or a decrease in price. For an increase in oil crude price it is expect a reducing demand, but it is not necessarily true that a decreasing oil price would lead to an increase in demand of the same measure for example an increase in oil price can be ill-used in order to invest heavily on innovation and new equipments that would increase oil production leading to a positive impact on price. Last but not least, there is another important aspect concerning demand elasticity that has to be taken into account the responsiveness of oil demand to a new peak price is different to the responsiveness of oil demand to a price recovering9. It is possible to describe two different elasticity scenarios at different price levelselasticity of demand during increase in oil price that lead to new pr ice records,elasticity of demand during increase in oil price following a low point in price historyAs expected, some studies argues that higher responsiveness of change in oil price can be seen when oil price is reaching new records, while there is a lower elasticity for other changes in price level.Thus, to summarize, elasticity of demand is not always linear, it may respond asymmetrically to changes in oil price and it can be different depending to historical price level.Income elasticity of price crude demandIncome elasticity of crude oil demand measures the change in quantity of oil demanded for a given change in income. As the graph xx points out, income elasticity is more responsive in comparison to price elasticity the long run elasticity ranges from 0,4 to 1,4. Moreover there is an important difference between income elasticity of emerging market and OECD. Emerging markets shows higher income volatility demonstrating how important is oil in their production processes.Spare capacityA very important component and determinant of oil market is oil spare capacity, the amount of pointless production that oil producers can bring online quickly. The volume of spare capacity is fundamental as it can be a driver of oil price spare capacity is in fact utilized to balance excess of oil demand and it can be used to counterbalance temporary oil shock. In other words, spare capacity is a tool that offers flexibility to the market the higher the spare capacity, the higher is the ability to absorb oil price shock or respond to unexpected increase in demand. Thus in the short term, spare capacity can be exploited to offset increase in demand until oil supply is adjusted to meet demand.As the graph points out , there is an inverse correlation between oil price and spare capacity high spare capacity level is associated to weak oil price, while when spare capacity is low oil price is expected to be high or increasingly. Spare capacity evolution over years have dropped fr om 10 million barrel per day of the late 90s to less than 2 million barrel per day or 2% of global oil demand in 2004. In particular, the increase in demand not covered by an increased in supply of non-OPEC countries has been met by OPEC using also spare capacity and therefore diminishing them. As expected, during the deferred payment crunch that took place in late 2008, oil price fell dramatically while the spare capacity increased reaching 6% of global oil demand.According to the International Energy Agency, OPEC spare capacity excluding Iraq, Venezuela and Nigeria, accounts for 5,54 million b/d.. in addition to this, other 5,8 million b/d are estimated to be producible by OPEC countries within 3 months.To sum up, it is clear the role of spare capacity in oil market economy a pertinent inventory allows to maintain the flexibility required in order to play an active role once an oil shock is predicted or strong is conducting price to new records. The key issue is whether it is po ssible in the current scenario to maintain or even increase spare capacity and which is the player that should take this responsibility. Should oil companies create bigger inventories, even if it is uneconomical from a profits maximization point of view to hold higher reserves than needed, or should national oil companies keep bigger reserves?Oil demand projectionsAccording to the World Economic Outlook of the International Monetary Fund issues in April 2009, global oil demand is expected to grow by 0,6% or 540000 barrel per day per year on average between 2008 and 2014. World oil demand will therefore increase from 85,8 mb/d to 89mb/d while in a more conservative scenario it is expected that demand will remain stable around 85 mb/d depending on how fast and how strongly global recovery will take place.Given the recent historical standard of oil demand it is highly probable that non OECD countries will drive oil demand growth within the next future oil consumption in OECD countries will tighten. Asia, Middle East and Latin America will increase their oil demand by 2,6%, from 38,3 mb/d to 44,6 mb/d over 2008 to 2014 on average per year while at the same time, OECD consumptions will declined by 1,1 from 47,5 mb/d to 44,4 mb/d. As the graph points out, by 2013 non-OECD oil demand will be equal to OECD oil demand.The growth in oil demand of non-OECD reflects higher GDP growth expected as well as higher income elasticity to crude oil. In fact in several emerging market, oil price is administered in Iran for example gasoline costs just 0,8 per liter while OECD countries are usually more responsive to oil price changesMacroeconomic VariablesExchange RatesThe relationship between commuting rates and oil prices is complex and it is necessary to note that generally when there is a depreciation of the dollar, oil price expressed in dollar increases. world dollar the most widespread currency for oil price, a lower exchange rate of the dollar to another currency leads t o a minor orthogonal currency cost of oil causing a rise in oil demand. This increase in demand put upward pressure on the price of oil. Having said that, it is not possible to estimate a precise relationship between oil price and the value of dollar exchange rate all it is possible to say is that oil price moves roughly proportionally to change in dollar value ceteris paribus. Thus a 10% increase in nominal exchange value of the dollar causes a 10% decrease in oil price expressed in dollar, ceteris paribus. As the graph XX shows, the dramatically decrease in exchange value of the dollar since 2002 and the strong increase of WTI crude oil price in different currencies, would suggest the inverse relationship between oil price and dollar exchange rate is true even if it is not possible to evaluate to what extent. Looking at the relationship between oil price and exchange rate, another important factor that should be taken into account is the decision of leading oil exporters if dolla r depreciates against other currencies, oil exporters international purchasing power declines. In order to protect their interest, leading oil exporters tend to tight oil supply, leading to an increase in oil price.Another issue that should be taken into consideration looking at the exchange rate is that United States is a major oil producer and oil consumer an increase in oil price has therefore a double effect it leads to a deprecations of dollar against the currencies of exporting countries and an appreciation against the currencies oil importing countries. Even if this two divergent movements of exchange rate should be cancelled out each other, in the last years oil imports of oil in the Unites States has soared causing a major concerns in the American capability to respond to and increasing trade deficit influencing ostracizely the value of the dollar.Interest ratesThe relationship between oil price and interest rate is not univocal as it is impossible to identify a singular a nd unique effect of changes in interest rate on oil price. Generally the correlation between these two data is inverse as a decrease of interest rates would lead to increase in price. On the contrary, a decrease of interest rates in order to recover from a financial downturn would lead to a decrease in oil price which would suggest a positive correlation.An explanation of the reason why there is a negative correlation is that an expansionary policy causes a cost reduction of storing cost for commodities goods, driving up the oil price. On the other hand, a change of U.S. interest rate will have an impact on the pegged currencies to U.S. dollar or to the currency currencies which are traded against the American one too expansionary policy in the U.S. may not be proper to foreign central banks influencing foreign economic growth and consequentially oil prices.Oil price speculation or massive change in oil fundamentals?One of the main issue related to oil price is whether increasing v olatility and rise in prices during the last decade has reflected a massive change in oils fundamentals or if market speculators played an active role in massive price fluctuations. In particular it is necessary to understand if the oil price reached the high ever level in 2008 due to growing flow of money in oil derivatives or due to enormous change in underlying fundamentals, supply and demand. An increase from $28 per barrel in early 2002 to over $100 per barrel at the end of 2007, heading to the record $140 in 2008 and then falling below 40 by the end of 2008 is the result of the burst of an energy bubble or it the natural evolution of oil price during a worldwide financial crises? In other words, it needs to be investigated if the strong increase followed by the collapse in oil price is a cause or a result of the main worldwide financial crises.As analyzed in the first part of the dissertation, oils demand and supply during the period 2002 and 2008 changed significantly emergin g countries such as China and India drove oil demand while at the same time, oil suppliers reacted slowly and they tighten spare capacity. Those that support oil demand a