What if the price of oil goes up, if it goes down, if it goes back up…
A topic that always appears in the news, because oil is still the fuel that moves the world today.
But how and who set the prices of oil prices? How does it affect us as consumers? And what is the current market situation?
First let’s start by explaining a basic principle when we talk about the consumption of any goods, products or services and how its price is fixed. Many of you will know what I am talking about, it was the first theme of the repertoire of any introduction to the Economy. Exactly, it is the principle of supply and demand presented by British economist Alfred Marshal, and subsequently recovered by other famous economists most notably Adam Smith as well as others.
Let us define this basic principle of the economy in parts. The clearest definition of the offer is the number of goods or services that a seller puts on sale in the market. In this case, we have the number of barrels of oil in one hand. On the other, we have the demand, which is the number of goods or services that a group of people wants to acquire. The principle of supply and demand says that the price of a product will be at an equilibrium point where demand is equal to supply, and that balance point is the price that consumers are willing to pay to acquire that goods or services. Let’s see how it works and what factors affect the increase or decrease in the price of oil. The demand for oil is still quite important even today as black gold generates around 35% of the world’s energy (Chart 1). Therefore, we are relatively dependent on this fossil energy since we need it to move public or private transport, to generate electricity, to run the industry and, consequently, the world economy. The remaining 65% of the energy required is generated by other types of sources such as gas (23,46%), coal (28,15%), hydraulic energy (6,27%), nuclear energy (5,79%) and finally renewable energy (0,91%).
Next, we will explain how the price of oil evolves. Demand for oil increases with economic growth, the more the economy grows, the more oil is needed for factories to keep up with the increased production. In addition to consuming more, more fuel is needed to transport goods. This, in turn, generates even more demand, thereby causing a price increase. The exact opposite happens when the demand of the consumers is contracted since a lower demand, less need for energy in factories, less need for transport, etc.
The most recent examples are in the recent financial crisis of 2007-2009, as you can see in the chart attached (figure 2). Where oil went from about $ 140 a barrel to about $ 50 in a short time. The boxes in green show growth of the economy, therefore, greater demand for oil. However, there are other factors that can affect the increase or decrease of the price as we will see later.
And who are the countries that consume the most?
Well, mainly the most developed countries such as the United States, Canada, Germany, France, Italy, United Kingdom, Japan, etc. Other large oil consumers are developing countries with strong growth in their economies, as is the case of the Chinese giant, India or Brazil.
As we mentioned before, another important aspect to fix the price of a goods or services is the offer. Let’s analyse it.
The largest oil producers are:
It is not just about extracting the oil and selling it in the market but about placing it strategically. Therefore, in 1960, 5 of the world’s largest oil exporters (Iran, Iraq, Kuwait, Saudi Arabia and Venezuela) founded OPEC, which is the Organisation of Petroleum Producing Countries, in order to influence the price of oil in their favour. Subsequently, over the years, other countries such as Angola, Algeria, Ecuador, the United Arab Emirates, Gabon, Equatorial Guinea, Libya, Nigeria and the Republic of the Congo were added. There are currently 14 member countries.
But what does OPEC do? What percentage of the market does it dominate?
It is an organisation consisting of 14 countries as we mentioned previously. By some economists and analysts, it is considered as an oil cartel. OPEC intends to control the supply in the market so that it can defend the interest of its members and mainly that of Saudi Arabia, the world’s largest exporter until 2017. Each member country has quotas to respect according to their levels in order to maintain an attractive price. for their interests
For example, when the economy is stagnant or in recession, OPEC tends to cut oil production to cause reduce the supply in the market. This in turn allows the prices to remain high and aligned with its interests. That is why they were very controversial in the 70s when there were embargoes that caused the price of each barrel to triple. The measures that OPEC can take in terms of supply have an impact on the price of the barrel since in its entirety, the organisation controls around 30% of the global supply with 2019 data, far from the 35% quota of 2012.
What about the other Producers?
Let’s analyse the other 70% of the market. This part is very important not only because of the growing percentage but also because of its actors. Within this market share, we have actors as important as the United States that is currently the largest oil producer in the world, with a market share of 18%. Some analysts believe that, in a few years, the United States will be self-sufficient thanks to the liberalisation of fracking. Which has caused the world’s largest economy, the United States, to stop importing as much, which in turn, has caused the price to drop in recent years.
And what is fracking?
Also known as hydraulic fracturing is a technique that allows the extraction of gas or oil. The technique consists of drilling a vertical or horizontal well, tubed and cemented, more than 2,500 meters deep, with the aim of generating one or several channels of high permeability through the injection of water at high pressure, so to overcome the resistance of the rock and open a controlled fracture at the bottom of the well, in the desired section of the hydrocarbon container formation. This pressurised water is mixed with some propping material and chemical products, to expand the existing fractures in the rocky substrate that encloses the gas or oil, and that are typically less than 1 mm, and thus favour its exit towards the surface.
Another of the big players within this 70% is Russia, which has 11% market share, China with 5%, Canada with another 5% or Brazil with 3%.
As we have mentioned, the United States has become the largest oil producer in the world thanks to fracking, the greater its production, the less its dependence on imported crude oil and the greater its market share, therefore, OPEC’s power decreases and the price does the same. However, on the other side of the balance of non-OPEC countries is Russia, which is the third-largest oil producer in the world, only behind Saudi Arabia, and which in recent years has become an ally of OPEC despite being opposed on many issues from the Middle East to Saudi Arabia.
In July of this year, OPEC formalised an alliance with Russia in order to further control the oil market. As a result of this alliance between the organisation and Russia, they now control around 41% of world crude oil production. This shows us that black gold achieves incredible alliances despite the fact that Saudi Arabia and Russia have opposite opinions on most geopolitical issues in the Middle East, such as the war in Syria and many others.
Some analysts believe that this strategy favours Vladimir Putin mainly since the world’s largest oil producers are in the Persian Gulf area. For its part, the United States, as you may know, has imposed sanctions on countries such as Iran and Venezuela, large exporters of crude oil, which has limited its exports and fully affected OPEC.
As we mentioned earlier, the price of oil is not only governed by the law of supply and demand but also by other aspects such as geopolitics or other issues that may affect supply. The most recent case is that of the drone attack on the oil facilities in Abqaiq and Khurai in Saudi Arabia during the weekend of 14 September 2019. This caused a 20% rise in the price in just 48 hours. These facilities produce around 5 million barrels per day.
And how does the increase in oil prices affect us as consumers?
The first impact we notice as consumers is when refuelling our cars to get around. Increases in oil have an impact on the costs of transport and freight carriers, which in turn increase the price of the goods. It is like a snowball that is enlarging as it descends the mountain, the domino effect falls on the end customer.
In some oil exporting countries such as Saudi Arabia, Venezuela or Algeria there is something quite anecdotal and that is that the State pays part of the prices of gasoline and diesel. Therefore, it is not surprising that in countries like Venezuela or Saudi Arabia the prices of a litre of petrol or diesel are cheaper than a bottle of water.
What is the current market situation?
According to analysts, faced with fears of a new recession, black gold prices may decrease further, from the current $ 62 to around $ 50 or even less. To all this we must add the incorporation of restrictions on the use of polluting vehicles, the limitations to access certain central areas of large cities and other measures that are causing a small change of mentality in the consumer to acquire electric vehicles or use plus public transport. This affects the demand for vehicles and the respective fuel consumption to travel.
The oil issue is extremely complex, more than any other raw material, due to all the aspects that surround it such as the conflicts in the Middle East – an area that has large reserves of crude oil -, geopolitical interests, geostrategic alliances and principle of supply and demand.
Despite all this, it remains the most polluting and harmful fuel for the environment and yet it is the industry’s favorite and will continue to be until the new environmental regulations and the change of mentality are not sufficiently present to change customs and habits of modern man.