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Factors That Affect the Market Price of Oil

THE FACTORS THAT AFFECT THE MARKET PRICE OF A PRODUCT SUCH AS THE WORLD PRICE OF OIL IN THE PAST TWO DECADES.

BRIEF: 103737

INTRODUCTION

In order to have a good understanding of the factors that affect the market price of a product, one will first need to grasp the meaning of what a market is. A market can be defined as an area over which buyers and sellers negotiate the exchange of some product or related group of products. It must be possible, therefore, for buyers and sellers to communicate with each other and to make meaningful deals over the whole market. Individual markets differ in the degree of competition among the various buyers and sellers. In some cases where the number of buyers and sellers is sufficiently large no one of them will have any appreciable influence on price. This is what is known as a perfectly competitive market. However, for the purposes of this essay we will stick to the concept of a market.

Using the table below we will show how the market price of a product (bread) is affected.

Demand and supply schedules for eggs and equilibrium price

Price per dozen Quantity demanded Quantity Supplied Excess demanded minus quantity supplied
0.50 110.0 5.0 105.0
1.00 90.0 46.0 44.0
1.50 77.5 77.5 0.0
2.00 67.5 100.0 -32.5
2.50 62.5 115.0 -52.5
3.00 60.0 122.5 -62.5
5.00 80 152.5 -72.5

From the table above we can see that the quantity demanded is much higher than the quantity supplied at 110 and 5 and the price is £0.50. This shows an excess demand of 105. When the quantity demanded is 90 and the amount supplied to the market is 46, we have excess demand of 44 we correspondingly have a market price of 1. However, when the quantity demanded is 77.5 and the quantity supplied is 77.5, the market price for bread is £1.50. At this point the quantity demanded is the same as the quantity supplied. At such a price consumers wish to buy exactly the same amounts as the producers wish to sell, this is known as the equilibrium price. At prices above £1.50 the quantity supplied exceeds quantity demanded. Furthermore, the higher the price, the lower the excess of quantity demanded over quantity supplied. The amount by which the quantity demanded exceeds the quantity supplied is called the excess demand, which is defined as quantity demanded minus quantity supplied (qd – qs). This is shown in the last column of the table.

Finally, consider prices higher than £1.50. At these prices consumers wish to buy less than producers wish to sell. Thus, quantity supplied exceeds quantity demanded. Furthermore, the higher the price, the larger the excess of one over the other. In this case there is negative excess demand (qd – qs < 0). Negative excess demand is usually referred to as excess supply, which measures the amount by which supply exceeds demand (qs – qd). This leads us to the concept of the law of price adjustment. This law predicts what will happen to the market price when there is either excess demand or excess supply. When supply exceeds demand, the market price will fall. When demand exceeds supply, the market price will rise. This law of price adjustment makes considerable sense and conforms with common experiences of how markets work – shortages of any product tend to lead to price rises while gluts tend to lead to price falls. Most importantly, it implies that prices will move towards the level at which demand and supply will be equal. Whenever, the current price is not the one that equates demand and supply, the law of price adjustment ensures that the price will move towards the market-clearing price rather than away from it. When quantity demanded equals quantity supplied, we say that the market is in equilibrium and vice versa. It will be worthwhile to note that although demand and supply analysis which act as the main factors that affect the market price of the product, it helps us to understand all markets, even though the details of how they actually work varies considerably from market to market. In addition, a product which has close substitutes tends to have an elastic demand, i.e. the demand of the product would be very sensitive to shifts in its price, and one with no close substitutes tends to have an inelastic demand, i.e. the vice versa of the previous mentioned.

Now that we have understood the factors that affect the market price of a product, we can now move on to talk about the factors that affect the fluctuations in the price of oil for the past two decades.

In 1985, the price of oil (Saudi Arabian Light) was $27.53 per barrel[1] (yearly average). The price of oil during this period was falling, in which in 1986, the Saudi’s abandoned the swing producer role because they had the largest reserves of oil and capacity utilization to stabilize the price of oil when there was a shortage in the world oil market. By 1987, the price of oil had dropped to $16.95. In 1988, it dropped further to $13.27 and $15.62 in 1989. In 1990, Iraq invaded Kuwait in what turned out to be a huge blow to the stable price of oil. The oil price rose to $20.45 per barrel. The major reason for this is that both Iraq and Kuwait were members of OPEC and due to the war there was a shortage of oil in the world oil market which led to an increase in the price of oil. Between 1990 and 1991 America launched operation desert storm, which was to help Kuwait against Iraq. This also contributed to the rise in the price of oil as America is the largest consumer of oil, and they needed it during the military campaign of operation desert storm. In 1991 and 1992, the price of oil decreased to $16.63 and $17.16 respectively. In 1993, it fell again to $14.95 and $14.74 in 1994. In 1995, the price rose to $16.10, and in 1996 it shot up to $18.52. In 1998, the price initially dropped to $12.21 but shot back up again to $17.25 in 1999. The main reason for this during this period was that there was an Asian economic crisis; the Iraq oil-for-food programme which helped in stabilizing the price of oil in 1998. In 2000, the price of oil leaped to an astounding $26.20. The reason for this was that due to the decline in the price of oil OPEC members decided to cut back production in order to stabilize the price of oil, before it went below the amount various member countries of OPEC will be able to cover the cost of producing oil. In 2001, the price decreased to $22.81, and in the same year (Sept. 11th) there was an attack in the US which destroyed the world trade centre. In 2002 to 2003, the price of oil rose to $23.74, and $26.78 respectively. This came about due to strong demand growth mainly from countries like China, and India, in which in 2004, the price of oil jumped to an ecstatic $33.64. In the present year of 2005, the monthly average of the price of oil has reached $63 a barrel. However, for reasons to do with accuracy, we have decided not to use 2005 figures since we are still in the year. The following graph represents the trend in the world price of oil over the past two decades.

Data source: BP Statistical Review of World Energy, June 2005.

On the supply side, the main players in the crude oil market are OPEC, which currently provides about 40 percent of world supply and hold about 70 percent of proven oil reserves, and non-OPEC producers who own the rest. OPEC as the marginal supplier does act like a cartel in most cases, i.e. they collude to restrict the output of oil and raise the price far above their cost. In recent years, its policy has been to balance the market while allowing for an appropriate level of crude oil inventories in consuming nations. Non-OPEC producers, on the other hand, have relatively limited reserves and spare capacity, and generally behave as price takers. Currently, the estimated reserves of OPEC are 890 billion barrels, as opposed to 177 million barrels for non-OPEC members. In the latter years, world events such as the Iran and Iraq war, the Asian economic crisis, the invasion of Kuwait by Iraq, and corporate social responsibility such as country legislation which regard environmental pollution as high on the agenda (in some country’s environmental pollution is stricter than others in order to produce oil, e.g. Nigeria has a less stricter environmental pollution legislation compared to Saudi Arabia) have all contributed to the fluctuations in the world price of oil. However, of recent, the strong demand growth from Asia and China in particular can be said to be the reason why the price of oil is rising. The consumption of oil in 2004 grew by 2.9 million barrels a day (mbd) (3.7 percent of which China contributed about 1 mbd) relative to 2003, which can be said to be the largest increase in the past 20 years. With notable exceptions of Iraq, Russia, and Saudi Arabia, the world’s oil producers may be close to their short-run output capacity. Thereby, continuing increases in demand and the possibility of even minor disruptions (Hurricane Katrina (US), Industrial disputes (Nigeria), environmental concerns (Nigeria)) in supply thus help in explaining the high market price for oil. Investment in refining capacity has been too low, and a mismatch has emerged between the type of refining capacity now required and what is available. For sometime, world oil demand has been driven by high-quality light crude (oil of low density or containing a low wax content, which makes production and refining easier) and by sweet crude (oil with a low sulphur content). Recent additions to production capacity by OPEC have though largely been in the heavy and sour grades of crude, which are more difficult and costly to refine. This lack of investment in appropriate refining capacity and limited substitution possibilities has pushed the retail price of oil up. Another reason which can be said to this lack of investment by OPEC members is a price collapse. When demand falls and the quotas allocated to member OPEC countries breaks down, the price can drop dramatically. For example, in 1997, OPEC raised its production ceiling by 2.5 million barrels per day in anticipation of growing Asian demand, but the currency crisis of late 1997 instead caused Asian demand to fall. The result was a market price in 1998 that dipped to as low as $12.21 per barrel, the lowest level since 1973, and a $51 billion year over year reduction in oil revenue. In addition given continued uncertainty over the pace of China’s economic development, OPEC may be cautious in expanding supply capabilities due to this. This uncertainty of slow or minimal investment contributes to high futures prices for oil delivery several years ahead. One should also note that since 1986, most oil exporting countries have been burning more oil than they have discovered and since 1998, there has been a fragile balance between supply and demand. Oil is being found at a lower rate than what has been consumed, i.e. we are finding reserves at 7 billion while consuming oil at 30 billion barrels per annum (Exxon-Mobil estimates), hence the law of price adjustment and equilibrium can be said to have taken place.

SUMMARY AND CONCLUSION

This paper has looked at the definition of what a market is. We have also mentioned the concepts of demand and supply with regards to equilibrium and the law of price adjustment. The erratic movement in the price of oil in the past two decades are also looked at. Issues of what factors cause fluctuations in the price of oil such as, the lack of investment by various OPEC member countries into oil production so as to keep up with the world demand of oil, the increasing demand of oil from Asia and the Peoples Republic of China, and the uncertainty of the oil market are all mentioned.

It will be worthwhile to conclude that although at present these factors seem to be the norm that affects the price of oil, one should be more cautious into the future, as with hindsight these factors could become obsolete with time passing by. Potential factors which could turn out to be embedded in the future range from alternative sources of energy to synthetic fuels, in which in the long term the demand of oil will continue to exceed supply until the previous mentioned becomes entrenched in most economies.

BIBLIOGRAPHY

Asian Development Outlook, (2005), The challenge of higher oil prices.

BP Statistical Review of World Energy, (2005), Putting energy in the spotlight.

Berkmen, P., Ouliaris, S., and Samiei, H., (2005), The structure of the oil market and causes of high prices, research department, International Monetary Fund.

Chrystal, K.A., and Lipsey, R.G., (2004), Economics, Tenth Edition, Oxford printing press.

International Energy Agency, (2004), Analysis of the impact of high oil prices on the Global economy.www.iea.org/textbase/papers/2004/high_oil_prices.pdf.

International Monetary Agency, (2004), Analysis of the impact of high oil prices on the global economy, research department, December.

Saxton, J., (2005), Explaining the high price of oil, Joint Economic Committee, Research Report, United States Congress.

Serrapere, J., (2005), Crude Oil – Energy and Market Outlook, September.

APPENDICES

Saudi Arabian Light (World’s largest producer of oil (Swing Producer))
Year Oil price
1985 27.53
1986 13.1
1987 16.95
1988 13.27
1989 15.62
1990 20.45
1991 16.63
1992 17.16
1993 14.95
1994 14.74
1995 16.1
1996 18.52
1997 18.23
1998 12.21
1999 17.25
2000 26.2
2001 22.81
2002 23.74
2003 26.78
2004 33.64

Source: BP Statistical review data 2005

The following table since 1999 shows that there has been no ‘Real’ excess oil supply.

Estimated Annual World Oil Demand Growth 2000 – 2005 (million barrels daily) % Change

Sources of Demand 2000 2001 2002 2003 2004 2005 2000 to 2005
World Demand 76.7 77.4 78 79.7 82.5 83.9 9.4%
World Demand Growth Over Prior Year 0.7 0.6 1.7 2.8 1.4 NA
Non-OPEC Supply 46.4 47.1 48.1 48 50.1 51 9.9%
OPEC Supply 30.3 30.3 29.9 30.7 32.4 32.9 8.6%
Sources of Supply 76.7 77.4 78 78.7 82.5 83.9 9.4%
Crude Prices Since 01-01-00 (per barrel) 25.8 19.8 31.2 32.5 43.5 70.0 171.6%

Source: IEA monthly oil report July, 2005.

 1 


Footnotes

[1] The reason we have used US dollars is that it is predominantly used internationally as the currency to benchmark trade.



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