FACTORS FOR HIGH OIL PRICES
Market players attribute the sharp increase in prices to various factors. The main factor has been strong economic growth in the U.S and china. At the same time, higher growth in the U.S economy, which devours 25% of all world oil, is driving competition between Asia and the US for the supplies .In fact, China has overtaken Japan as the second biggest consumer of oil after the U.S and their increased consumption has lead to increase in demand of oil. The market has also speculated on shortages arising out of constraints in sources as varied as Russia (because of the clampdown by the tax authorities on Yukos, a major oil producer, Yukos pumps a fifth of Russia's approximate 8.5 million barrel a day output but faces bankruptcy and/or dismantling over huge government demands for back-taxes)
Violence in the Middle East, Ethnic tension in Nigeria, Strikes in Venezuela. at a time when the demand for oil has been booming in the U.S., China, India and other markets.. Fears of continued unrest and outright civil war in Iraq, removed a potentially large source of additional crude oil supply. Bottlenecks in Russian export capabilities. The fear of terrorism and unrest in Saudi Arabia and major Middle Eastern producing countries including a deadly attack by Islamic militants in Khobar, and a fear that al Qaeda-linked forces are trying to provoke civil war in the kingdom have again raised fears about supply interruption. The Weaker U.S dollar-A 10% drop in the dollar against Currencies of other oil-consuming countries means a 7.5% rise in the dollar price of oil. Recent events in Iraq and Saudi Arabia particularly attack on Yanbu has resulted in supply disruption. Investment has been low in the Persian Gulf and Caspian Sea. Mature U.S and North Sea oil fields are producing less and new finds have dropped to 6.8 billion barrels annually in 2001-03 from 11.4 billion barrels per year in the previous 5 years. The rate of demand growth has caught forecasters by surprise, with the lack of refining capacity in the US also putting pressure on prices. Supplies from Iraq are hampered by regular acts of sabotage and the There is slow recovery of production in Gulf of Mexico, where 17 million barrels of oil production have been lost since hurricane Ivan whipped through the region mid
ANALYSIS
James Burkhard, Director of oil market analysis for Cambridge energy research associates in Cambridge, Massachusetts said “Demand Growth this year will be double the average rate of growth for the prior six years”. World’s oil production comes from more than 825,000 oil wells. More than 520, wells of these wells are in the United States, which has some of the most mature producing basins in the world. Analysts have also said “oil is the Third Whammy”
The latest (August) monthly Oil Market Report of the International Energy Agency (IEA), which primarily represents the interests of the advanced industrialised oil-consuming nations, terms the oil market as being afflicted by "Irrational exuberance". It observed that although the demand-supply balance was "tight", the market had been "living with greater uncertainties for quite some time now".
According to the IEA, the global demand for oil was 79.6 mbd in 2003 and it was expected to increase to 82.2 mbd in 2004. Demand in the second quarter of 2004 increased at the rate of more than 5 per cent, the highest in the last six quarters. Demand has been particularly strong in the U.S., which was the biggest consuming nation, accounts for one in four barrels consumed in the world, and in China. The scorching pace of the Chinese economy during the last calendar year, and the stockpile that it is building currently are believed to have contributed to the higher Chinese demand, which increased from 4.7 mbd in 2001 to 5.9 mbd in the third quarter of 2003.
In the first 90 days of 2004, oil prices leapt by more than $7 a barrel, when the gap between supply and demand was about 2 mbd, according to data released by the IEA. Oil market commentators say that this price increase does not represent a normal or rational response to a supply problem. The problem is that since oil, the most important energy resource, is so basic to economies and societies across the world, its demand is relatively inelastic to price, at least in the short term. Thus, a minor shortfall in supply can trigger a relatively disproportionate increase in prices.
DEMAND ANALYSIS
Demand is the quantity of good consumers is willing and able to buy at various prices over a given period of time. Demand curves do not stay permanently in one position. Over time, demand will shift because of changes in: price, level of income available to consumers, the price of substitute or complementary goods, the distribution of income among different classes of consumers, the demographic structure and age trends, expectations of future prices and income changes, advertising. Each Demand curve is defined relative to its own price for given levels of these other variables. If they change, the demand curve will shift. The term and ’Increase’ or ‘Decrease’ in demand, by conventional usage, is used to denote an outward or inward shift in demand curve.
In Diagram 1.1 it is shown that Real income of consumers in a country rises. Demand for Oil increased. There is a shift in demand curve from D1 to D2. At first the equilibrium was at A because of the demand curve D1 and Supply curve S1 which shows that the quantity demanded was Q1 and the price was P1.Now as the income has increased people are able to buy more oil. So the demand curve shifts to D2 from D1, which shows the new equilibrium point at B, where the quantity demanded is Q2 and the price has increased to P2. So as the demand increases the price also increases, supply remaining constant reflecting the power of the income effect.
SUPPLY ANALYSIS
Supply is the quantity of a good firms are willing and able to supply at various prices over a given time period. Supply curves also shift position because of changes in Price, technological innovation, change in price of labour, capital and material inputs, natural calamities and man-made disasters (war, weather, fire), strikes and government regulations, organisation and management restructuring.
In Diagram 1.2 it is shown that Saudi Arabia discovered a cheaper way of producing oil. This meant that, at each price level, more output can now be produced. We represent technological innovation of this type as an outward shift in the supply curve from S1 to S2. At first the original equilibrium point was at E because of demand curve D1 and the supply curve S1 that shows that the price was P1 and the quantity supplied was Q1. The supply curve shifts from S1 to S2 as the result of the cost-reducing innovation and we can see new equilibrium point at E1 where price is P2 and quantity supplied is Q2.When the cost of supplying goods come down you will supply more because there will be more profit margin and so there will be more production.
PRICE ELASTICITY OF OIL
Demand for oil is price Inelastic. The ease with which the consumer can substitute another good determines price Elasticity. Goods with few substitutes like oil are Price inelastic. When proportionate change in quantity demanded is smaller than the proportionate change is Price.
This analysis shows demand for oil in the short and long run. The long run demand curve is generally more elastic than the short run demand curve. Price elasticity varies with time. Consumers may take time to respond to changes in price. In the long run consumers have more time to adapt to price changes.
In diagram 1.3 it is shown that as supply reduces which shifts the supply curve from S0 to S1.Relative prices shift from PO to P2 and quantity supplied moves from QO to Q2 because of violence in the middle east which is only one of the factors for rise in oil prises. This shows that when costs go up supply (production) decreases because there are fewer profit margins. The slope of the long-run demand curve indicates that people have had more time to adjust to price changes, which is shown by movement in price from P2 to P1 and relative quantity from Q2 to Q1.
We can see from the chart below that in July 2004 oil cost around 25% more than it did at the beginning of 2004.
Source: Sloman,J and Beharrell ,A (2004),Economics for Business,(Third Edition)
chapter Resources [Topical Economic Issues-The Relentless rise in oil]
SPECULATION
The purchase or sale of a Commodity, currency, shares in anticipation of a change in its price. Speculators are individuals or financial institutions that buy or sell commodities or financial assets with the intention of profiting by selling them (or buying them back) at a later date at a higher (lower price). If Prices are expected to change in the near future, this may affect the current behaviour of buyers and sellers now. If there is an expectation that prices will rise in future the attitude is buy now and sell later and if the expectation is that prices will fall in the future the attitude is sell now and buy later. Speculation tends to be self-fulfilling-the actions of speculators tend to bring about the very effect on prices that speculators had anticipated.
The collapse of the stock market a few years ago, the fall in interest rates, and fewer opportunities to bet on currencies have caused speculative adventurers to focus their attention on commodity markets, particularly oil. Hedge funds and other financial players are active in the futures contract market for oil. The peculiar features of oil, its relatively low elasticity of demand, and its strategic importance offer advantages that other commodities do not offer speculators. After all, when oil prices touch $50 a barrel, there may be buyers who may see it fit to buy at that price rather than wait to see prices touching $60 a barrel. In short, its volatility is what makes oil an ideal betting medium for speculators. The collapse of financial markets worldwide has caused hedge and pension funds to move into the markets for commodities like oil. The herd behaviour of such entities has caused further instability in the oil market. Speculators are not generally the drivers of high oil prices but once they become a major presence they can exacerbate and maintain a high price. The hedge funds have become major players in the oil market. Futures and their net long positions have been high for several months and Shows no signs of abating.
In Diagram 1.4 it is shown that with an Initial price increase of oil because of strong economic growth in china. Price rise from P1 to P2 is caused by increase in demand from D1 to D2. Speculators think that prices are going to increase further in future and so sellers (suppliers) will sell at a later date and wait until price rises further. Supply shifts from S1 to S2 and we can see demand curve has shifted from D1to D2 as quantity demanded increased because demanders buy now before any further rise in Price. As the result price continues to rise to P3, which leads to de-stabilizing speculation, which means that the actions of speculators tend to make price movements larger
REFERENCES
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