Why are oil prices so volatile?

Hello readers, welcome back to my blog on interesting economics news stories of the week. Last time, I discussed how Brexit might not be all bad news and how the disappointed remain supporters, including myself, should focus on the positive aspects instead. For the ‘remainers’ out there that didn’t read my post simply because they couldn’t face reading any more about Brexit or for those that didn’t get a chance to read it; some of the positives I considered were: how we could still allow immigration but in a more controlled manner whereby we could select workers that we needed for certain job sectors, as well as how leaving the EU, a major trade partner could allow us to trade with other countries and view them through the same lens, therefore providing greater trade flexibility. This week I will be looking at something quite different. OIL.

Oil from an economic point of view is much more than just the black, viscous liquid that comes to mind when the word is mentioned. It has the power to start wars, transform countries from being poor to rich, cause inflation, as well as ‘fuel’ globalization and transportation across the globe.

It’s common knowledge that oil is a fossil fuel and is a finite resource, meaning it will eventually run out and will not be able to be reproduced within our lifetime; although I suspect many of you don’t know why the price of oil has fallen from US$154 dollars a barrel in June, 2008 to US$29 dollars a barrel in January, 2016. How is this even possible considering the world’s oil supply is running out? Even more so, why are oil prices so volatile? I’m sure many of you will have experienced this first hand, for example when you fill up your car how come the price of filling up the tank on one day is different to when you fill up another day. Why can we not have fixed price for a litre of fuel? Surely if we know roughly how much oil there is in the world and roughly when it is likely to run out, you would think that we could work out what the price of oil really should be.
In today’s post, I hope to be able to explain some of these ideas and look at the fundamental economics behind oil prices and their volatile nature. If you are intrigued to find out more about this topic, keep reading on and hopefully it will become much clearer to you. Alternatively, we could just all go and install solar panels and purchase electric cars, then all this wouldn’t matter to us anyway. As always if you have any questions, please post them below and I will try to respond to them. Alternatively, you can send them directly to my personal email address-rajveersira@gmail.com

screen-shot-2016-12-23-at-17-29-54

So how much is left?

The truth is we don’t really know, although geologists, who scour the treacherous depths of the Arctic, or Brazil’s Atlantic pre-salt fields, or offshore West Africa, or the deep waters of the Gulf of Mexico, seem to think they have an answer. Rather unhelpfully they have all come to different conclusions meaning we could have anywhere between 1 trillion barrels to 3 trillion barrels left.

There are, however, reasons for this wide disagreement on the size of the remaining reserves. One reason is because we don’t know how easy or practical it will be to extract the oil from such area and there are arguments as to whether we should explore undisturbed areas including Antarctica. We do have a rough estimate however of much oil we have used since the 1800’s which is 850 billion barrels, and we are currently consuming oil at the rate of about 85 million barrels every day, or 31 billion barrels per year.

Okay so we can’t have a fixed price for oil because we don’t know how much oil there really is, but why are oil prices so volatile?

The main influencer of fluctuations in oil prices is the organisation known as OPEC-the Organization of Petroleum Exporting Countries. OPEC is an association made up of 13 countries: Algeria, Angola, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela and controls 40% of the world’s supply of oil. It sets production levels to meet global demand and can influence the price of oil and gas by increasing or decreasing production.

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OPEC said that it would keep the price of oil above $100 a barrel for the foreseeable future, however, in mid-2014, the price of oil began to plummet. It fell from a peak of above $100 a barrel to below $50 a barrel. OPEC was the major cause of cheap oil as it refused to cut oil production. As with any commodity, stock or bond, or currency, the laws of demand and supply can explain why oil prices suddenly changed. When supply exceeds demand, prices fall, likewise, when demand exceeds supply, the price must increase.

Natural disasters are another factor that can cause oil prices to fluctuate. For example, when Hurricane Katrina struck the southern United States in 2005 it affected 19% of the U.S. oil supply and caused the price of a barrel of oil to rise by $3. In May 2011, the flooding of the Mississippi River also led to oil price fluctuation.

Production costs can also cause oil prices to rise or fall. While oil in the Middle East is relatively cheap to extract, oil in Canada in Alberta’s oil sands is a lot more costly. Once the supply of cheap oil is exhausted, the price of oil could conceivably rise if the only oil left is in the tar sands. Even if we did agree to extract oil from Antartica, it is likely that this would be extremely expensive, thus leading to businesses collapsing. Only the super-rich would be able to afford oil and majority of the population could be priced out of the market.

Political instability all over the world, particularly in the Middle East causes oil prices to fluctuate, as the region accounts for a huge proportion of the worldwide oil supply. For example, in July 2008, the price for a barrel of oil reached $136, due to consumers’ fears about the wars in both Afghanistan and Iraq.

Demand for oil and energy is closely related to economic activity. It also spikes in the winter in the northern hemisphere, and during summers in countries which use air conditioning. Furthermore, if producers think the price is staying high, they invest, which after a time lag boosts supply. Similarly, low prices lead to a fall in the level of investment.

What next…

  • For the first time in eight years, OPEC has agreed to reduce output – and it was followed this month by the news that Russia and other non-Opec states will also curb exports. This is likely to mean higher prices, higher transportation costs and ultimately an increase in inflation.
  • “Predictions for 2017 by major organisations and investment banks are generally not widely diverging and hovering in the US$50-$60 range,” says Oilprice.com

 

The image below summarises in a nutshell everything discussed in today’s post:

why-oil-prices-fluctuate

Sources used:

http://www.investopedia.com/ask/answers/012715/what-causes-oil-prices-fluctuate.asp

http://www.nytimes.com/interactive/2016/business/energy-environment/oil-prices.html?_r=0

http://letthesunwork.com/challenge/reserves.htm

http://www.theweek.co.uk/oil-price/60838/oil-price-back-above-55-after-positive-supply-data

http://www.visualcapitalist.com/oil-prices-fluctuate/

 

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