The ups and downs of oil prices

The ups and downs of oil prices

Oil, like all other goods, is subject to supply and demand—the nature of oil and our society means oil is always in demand. Petroleum based products are everywhere and the need for petrol and gasoline is as stable and predictable as the demand for water. Across the world, people need petrol and diesel to function: transportation mainly, as most movement is fuelled by these products. This makes it fairly simple to predict the demand for petroleum products, and therefore oil—it’s linear and logical.

If you’ve got a product to sell, you’re pretty happy when demand is both high and straightforward. You can accurately predict how much you need to produce to sell it at a certain price—i.e. maximum profit. The price of oil is not arbitrary—rather it is controlled by a cartel of major oil producing nations seeking to fix production according to demand so they can all profit as much as possible. This cartel, The Organisation of Petroleum Exporting Countries (OPEC), comprises fifteen countries: Algeria, Angola, Ecuador, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, the Republic of the Congo, Saudi Arabia, the United Arab Emirates and Venezuela. Saudi Arabia is the de facto leader, and recent tensions among the GCC nations mean Qatar will no longer be a member from 1 January 2019. As of September 2018, these fifteen nations accounted for an estimated 44 percent of global oil production and 81.5 percent of the world’s ‘proven’ oil reserves. If these countries were the only countries with oil reserves, the price of oil would be entirely at their whim. However, some notable countries also producing oil are missing from OPEC’s ranks: Russia, for one, and the United States.

In 2017, the United States led the way in global oil production, pumping 13.4 percent of the world’s total output onto the market: the number one producer of oil is not an OPEC member. It’s not part of the cartel seeking to maximise profits through careful, timely production. Make no aspersions: OPEC is indeed a cartel. While usually attributed to the supply of drugs, a cartel is merely an organisation which fixes some aspect of a product to maximise profits—OPEC fixes production and insists its members comply with the fixing. If OPEC (read: Saudi Arabia) says restrict production, all members cut production and in 2017, that’s precisely what they did. Prices soared.

Meanwhile, the US struck black gold. States such as Texas have been associated with oil production, but it was expensive and uneconomical and production dragged its feet compared to the major oil producing lands. A decade ago, oil experienced a price spike, which incentivised production again in the US: producers invested heavily, under the assumption oil prices would remain fairly high. Hydraulic fracturing (fracking) unlocked vast amounts of oil trapped underground but this process is irreversible: producers were forced to produce oil rapidly to recoup the money they had lost. Advances in technology coincided with high prices and dramatically lower drilling costs. The US burst onto the oil market. Fast forward to 2014, and oil prices crashed, with OPEC launching a price war to regain their lost market share: instead of cutting production, they flooded the market with the resultant low price knocking dozens of US oil companies out of business. US production fell but not as dramatically as feared and when OPEC decided it was time for oil prices to rebound in 2017, US shale companies were able to ramp up output. Their expenses were lower and technology had improved again. Suddenly, the US was producing nearly 11 million barrels per day.

Understandably, OPEC was not happy about this and shifted strategy. With shale production continuing to experience lower profit margins, the wealthier OPEC nations were able to take the financial hit to drive prices lower and attempt to knock their competitors out of business again. Most notably: Saudi Arabia.

With the US and the Saudis producing so much oil, global supply has been pushed beyond the ideal level for maximum profit. When supply is too high, regardless of demand, the price drops—people aren’t willing to pay as much for an abundant product and there is choice of seller. Whoever is willing to sell it cheapest will reap the benefits in times of abundance. This oversupply isn’t just visible at point of sale for consumers: the futures market has been paying close attention to the falling price of oil. A futures contract is an agreement between two parties to exchange a commodity on a set date for a set price and such agreements are used by companies to guarantee they have the supplies they need flowing constantly. Market speculators also enter contracts in attempts to profit f their changing value: when the price increases, a contract becomes a good opportunity for the buyer, so the value increases, and the reverse is true. When a buyer loses money on the trade, the contract is devalued—as investors watch oil prices tumble, they sell their futures contracts as they’re losing money holding onto them. Sold contracts indicate a loss of faith in oil’s value as an investment; fewer people buy and the price falls again.

While global prices fall and people at petrol stations continue to rejoice, the US is sitting pretty. Despite lowered profit margins, the US Energy Information Administration (EIA) expects production to continue to grow to 11.5 million barrels per day: this may be downgraded from its original growth forecast, but it still represents strong growth with output topping Russia and Saudi Arabia. On top of this, internal oil production means the US is less reliant on foreign oil, with important security implications given its interests in the Middle East.

But the oil market will always be a global one and the US is seen as a bug in an otherwise stable system—the system is now taking steps to return to maximum profitability. OPEC will continue to have significant influence over prices but the system is also cyclical: higher prices mean more opportunity. Up and down we go.