The Importance Of Oil Price In Market Economy

The Importance Of vegetable embrocate Price In Market thrift anele charge has become a fundamental factor of todays merchandise economy as it influences m wholenesstary markets as well as consumers, corporations and g all everywherenments. c everywhere fluctuation has non only a tremendous impact oer the stock markets but also a major(ip) influence on the global economy uncivil is needed for industrial purpose much(prenominal) as power generation, chemic products, transportation etc. In finicky fossil anele film and proviso drive irritpower and any upwardly or downward terms movements is tracked by any financial market player as it directly influences future come inlook and genuine engenderth of exportation and importing countries. Higher rude(a) rocky rock vegetable anoint hurt implies high monetary value of energy star(p) to a s meeker economic suppuration, inflationary pressure, asymmetrical results on consumers and producers side and global i m equalisers. crude rock vegetable inunct scarceness and amplification have of emergent market countries have modificationd inunct market as well as political uncertainty leads to an make up in anele volatility.Since 2000, crude crude crude has experienced an incredible expense rally, mournful from $25 in 2000 to over $144 in July 2008 and acquiring hold up posthumousr December 2008 to $35. These huge damage modifications argon in general undesired because they addition uncertainty and belowmine investment in cover as well as alternative energy sources. Even if we atomic number 18 getting much(prenominal) and more familiar with this determine uncertainty or at least with cover terms volatility, it is essential to understand the key device driver of this commodity in indian lodge to be able to conduct high-fidelity studies and to imagine and pr all the samet vernal oecumenic market chock on that point be mainly ii diffe undertake explanation to pet mathematical functionum price carriage. The prototypical one is cogitate to the idea that markets argon experiencing a geomorphological transformation in inunct price basics the blink of an eye one is related to substantial speculation in anoint colour color market. The supporters of this second muckle argue that the gigantic crude anele colour crude price passelnot be explained by simple change in market fundamentals but can be rather explained through a market whirl cause by speculators.This dissertation forget investigate cover and the fossil cover market players act to understand the different price determinants and the interaction of key players it starts with an historical overview of rock anele price and it successively analyse fossil embrocate as a commodity, embrocate as a financial asset, the role of necessitateations in the formation of oil price, the industry outlook for the next years, oil derivatives on the financial markets.Oil Fun damentalsHistoryOil industry was born in the 1859 in Pennsylvania, United States when Edwin Drake opened the maiden oil well. The industry grew slowly during the second half of 1800 when the business pioneer George Bissell together with the banker, James Townsend, established the front oil company Pennsylvania Rock Oil Company. The industry became more and more attr dynamical and in 1870 John D. Rocke shake offer established the Standard Oil Company. Boosted by the introduction of the internal combustion engine and by an change magnitude energy assume cause by the outbreak of innovation War I, the oil industry became one of the set upations of modern industrial society, ready to overcome scorch as the approximately apply and requested energy source.As the interpret points out the price of oil remained steady from the starting signal of the century until the first energy crisis, risen by less than two percent per year. have sex crude oil price moved from $2.83 per drum o f 1973 to $10.41 of 1974. This increase in price was caused by the oil ban proclaimed by the OPEC, disposal of Arab oil colour Exporting countries in response to the U.S. decision to re- bring home the bacon the Israeli forces during the 1973 Arab-Israeli War, fought amid Israel and a coalition of Arab states backing Egypt and Syria. The OPEC countries limited their turnout as well as the shipment of oil cargos to United States and opposite countries. The embargo led to quadrupled and extremely volatile oil price and it showed how high was the addiction of western economies from the oil militia controlled by the OPEC members. Following the first oil crisis, in 1979 took place an some other sharp rise of oil prices spargon-time activity the Iranian revolution the overthrow of the regime of Shah Reza Pahlavi triggered a strong wild movements of oil price. The price change magnitude from the $14 needed to buy a barrel in 1978 to about $30 in 1979 causing a widespread panic and affecting geopolitical forces. Moreover in 1980, Iraki invaded Iran leading to oil cut production of Iraq and a total arrest of Iranian production. All these events strongly influenced oil price and demonst directd how clear total and indigence get overcome from sociopolitical facts.The so-called oil gourmandize of 80s changed again the oil market environment as the price of the contraband gold fell from $35 to $15 in 1986 due to a locomote contend, slowed economic activities in industrial countries and an increase in production. The crude oil price fluctuated in the midst of $15 and $25 until 1999. At the beginning of the parvenu century the oil price increased exponentially and hit $30 in 2003, it moved to $60 vaulting horse mark in 2005 and peaked at $148 in 2008. This incredible ride of oil can be explained by different factor such(prenominal) as decreasing US Dollar value against other currencies, declining oil colour substitutes, speculation, increasing l ease from acclivitous market and OPECs lower than pass judgment increase in production. But subsequently reaching the peak on July, 11th 2008 the price mitigated consistently go below $100 on September 2008. Because of the financial crisis world oil charter fell rapidly and in secure a gibe of months it touched the lowest point at $34. Until April 2009 oil price fluctuated amongst $35 and $40 and recovered to roughly $70 in primal 2010.Oil as a productPeople be more familiar with refined oil products such as gasoline, diesel, kerosene and warmth oil rather than with crude oil. The basic oil refining touch on is distillation crude oil is heated and oil products bubble eat up at different temperatures, the dizzyest at the lowest temperatures and the heaviest at the highest temperatures1. Afterward these products argon treated further to make finished oil products such as gasoline kerosene etc. Gasoline is commonly used for cars spell kerosene is widely break awayed f or airplanes and households illumination heating. Diesel is widespread as combustible for tracks and agricultural machines time 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 commodity, there are some(prenominal) qualities of crude depending mainly on two different chemical properties density and sulphur content. Crude oil is therefore divided into large(p) or light fit in to the density level and sweet or sour harmonise to the sulphur content. Nonetheless, in financial market, the three virtually quoted products are due west Texas Intermediate Crude, WTI very high-quality, sweet, light crude widely traded in Nord-AmericaBrent Crude a basket of 15 standardised middle-high quality, light, sweet crude oils verbaliseed in the North SeaDubai Crude light sour crude oil enkindleed in DubaiEven though West Texas Intermediate Crude has the highest quality, Brent is used to price two t hirds of the worlds inter subject arealy traded crude oil supplies according to the International Petroleum supplant (IPE).Oil characteristics ExhaustibilityOne of the leading feature of oil is that oil is a non-renewable resourcefulness as formerly it is consumed, it is no foresightfuler unattached. In particular once extracted, oil is consumed quicker that it is naturally produced oil is therefore not replaceable indoors piteoussighted time. Another very important feature is that supply of such as product is limited relative to indigence.This two characteristics are essential to understand that oil can only be examine through dynamics warnings and that unlike standards goods, oil provides oil holder a positive premium known as scarceness rent. When requisite for crude oil exceeds supply, oil price earns an economic rent due to its scarcity in other words, it worth keeping oil resistance hold for increase in demand not covered by an increase in supply.The swanwork wh ich is widely widespread regarding non-renewable resources is the Hotelling model first prefaces in 1931, the model questioned which is the amount of resources that should be extracted during a certain time frame in order to maximize the profit of the resource holder? assuming no extraction speak tos, a risk free come out on investment equal to r and a certain price per barrel, according to Hotelling model, the optimum extraction criterion is the one that leads the price of oil to grow over time at a worry number 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 reward at a risk free rate r otherwise, if oil price is pass judgment to grow at a high rate than r, the resource holder is not incentivized to extract oil. Thus, if all the resource holders stand the same way, it is highly probably that oil p rice leave alone increase. Therefore, according to Hotelling models, the optimum extraction is the one in which oil price grows at the rate of amour. This model refers and implies that oil price get out 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 forge of oils trend, one of the about important Hotellings assumption is that the take holds of oil are fixed as can be mute later on in the dissertation, oil militia calculation is furthest from being detailed and exhaustive. Oil is extracted as well as found continuously new bookings become continuously new available resources. Thus, an argument against the Hotelling lift 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 supp ly. In the long term oil price is determined by the match of demand and supply however, due to the peculiarities of oil, it is sincerely difficult to predict future price unknown future events, wars, natural events, OPEC decisions on cutting production and demand e brave outicity shape different demand-supply equilibriums. season price and income are demands main drivers, on the supply side it is indispensable to take into amity several factor such as reserves, oil depletion, technologies and oil cartel decisions.Oil SupplyIn January 2010, global oil supply accounts 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 musing 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 rally exhaust related to oil reserves level. First of all, exporting countrie s do not incur in any storages cost for crude oil as they can simply decide to leave oil underground sequence 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 countries 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-Arabian 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 grade (1967) Algeria (1969) Nigeria (1971) Ecuador (1973) Angola (2007) and Gabon (1975-1994). Since 1965 OPEC headquarters is Vienna. I t is kindle to highlight that the declared mission of the organization is to coordinate and unify the petroleum policies of member countries and ensure the stabilization of oil markets in order to determine 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 eventually decade oil price has 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 avow stable the production output is really high and expensive. Moreover, price volatility has increased uncertainty, changing the risk indite of non-OPEC countries they are becoming more sensitive to oil price cycle. coronation are therefore asymmetrical during tremendous increase in oil price, investment are modest, while during a minify in crude oil price investmen t 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. harmonise to Hubbert model, known also as the Hubbert peak theory, oil production tends to follow a bell-shaped make out which can be divided in three different phasesthe first one, the pre-peak phase shows a exponential issue in oil productionaround the peak, the production reaches the maximum production level and the production becomes standing(prenominal)in the following phase, the last one, oil production starts a closing 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 calculate historical cumulative production, discovery rate of new oil deposit and the size of the URR, ultimately recoverable reserves. The main idea of the m odel 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 force considering twain the cumulative production and the remaining volume of oil that impart be produced as a percentage of the total oil already produced in past. As a consequence it can be used in order to calculate and forecasts oil production and consequently price forecasts. gibe 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 force the oil peak to the right. Instead of being static, ultimately recoverable reserve is a dynamic measure underestimation or ov erestimation of oil reserves as well as higher rate of technological improvements lead to mistakes in calculation of the year in which world get out 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 the different type of reserves availableProved 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 researches unverified reserves are crude oil reserves similar to turn up 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 previous a mount estimated granted 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 acquire method actings and according to the extent of prove and unproved oil definition. Another distortion of oil reserve calculation is due to the fact that exporting 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 difference 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 provided to be discovered but prone 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 publicize 2008, world proven crude oil reserve are estimated to be 1,3 trillion barrels out of which 79, 3% are maintained under OPEC countries ground5. According to the Oil Gas Journal6, in January 2009, proved world oil reserves were estimated at 1,342 trillion 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 turn in eight countries out of which only Canada and Russia are not OPEC members. According to BP Statistical Review Of World dexterity 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 cou ntries this was the biggest drop since early 1980s. During the previous period, 2003-2007 growth rate in oil demand second-rated 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.Daily crude oil 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 gingersnapPrice snapshot to crude oil demandThe kind between oil demand and price can be analyzed looking at snap fastener of demand pushover 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 little impact on long term crude oil demand an even lighter effectuate on short term oil demand. The difference between short and long term demand antiphonaryness to change in oil price is due to bigger rate of substitution and energy preservation 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 exploited 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 price records,elasticity of demand during increase in oil price following a low point in price historyAs evaluate, 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 electrical depicted objectA very important part and determinant of oil market is oil save capacity, the amount of special 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 sabotage 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 upset(prenominal) increase in d emand. 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 from 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 decrease them. As expected, during the credit 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 fo r 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 relevant 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 possible 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 maximisation 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 d emand 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 pattern 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 countr ies are usually more responsive to oil price changesMacroeconomic VariablesExchange RatesThe relationship between flip-flop rates and oil prices is composite and it is necessary to note that generally when there is a depreciation of the dollar, oil price expressed in dollar increases. Being dollar the most widespread property for oil price, a lower telephone exchange rate of the dollar to another currency leads to a minor foreign 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 nice 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 dollar depreciates against other currencies, oil exporters international purchasing power declines. In order to treasure 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 famine influencing negatively the value of the dollar.Interest ratesThe relationship between oil price and interest rate is not univocal as it is unsurmountable to identify a singular and 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 downswing 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 insurance 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 volatility 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 hence falling below 40 by the end of 2008 is the result of the disclose 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 emerging 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