Oil is one of the most precious commodities in the world. It is the lifeblood behind the growth of any economy, developing or mature. Oil is the commodity that fuels our transport systems and various industries enabling our economies to remain mobile and growth-oriented. The price of oil can be decribed as the wild card of the inflation basket given the multivariate nature of factors that determine it, this lends to its volatility.Given its importance, oil tends to be somewhat of an inelastic commodity. Irrespective of price, the demand will remain constant or grow. If the price of oil doubles, there will not be a subsequent decrease in demand by half.
Consequently, one cannot base any assumptions about the price of oil on demand. To understand how oil is priced, one has to consider the supply side of the problem, not the demand side. There are three major pain points that can disrupt the supply (and cost) of oil: Extraction - Oil must be extracted from the ground. Price fluctuations can occur according to the costs associated with the cost per barrel of extraction. Limitations to supply can be associated with extraction capacity, cost of drilling, cost of search, environmental factors associated with drilling, etc. Demand can sometimes exceed output capacity, but typically prices rise when reserves drop (due to either demand or OPEC-induced cuts). Distribution - Once oil is extracted, it has to be shipped out to distribution ports or sent via pipeline to distribution centers. Supply can be limited by the availability of pipes, shipping infrastructure, weather, terrorist attacks, marketing, etc.
Refining - once the crude oil reaches a destination, it has to be processed and refined for various uses, one of them being petrol. The availability of refineries, their location, their distribution method, their capacity, and local laws governing the formulation of petrol play a role in the cost of petrol.Currency - as global oil prices are quoted in US dollars, the rate of exchange with various currencies typically impacts the end user. A weakening currency implies a higher fuel cost at a retail level.
Taxes - This doesn't really affect the supply of oil, but plays a significant role in its price. This factor tends to remain constant once adopted. The rate of tax on fuel depends on the governing body in a country. However, since this is constant, it does not tend to affect the price fluctuations of gas. It does however play a significant role in the disparity of gas prices between nations.
There are many price and non-price determinants of the quantity of oil supplied and demanded. However, as an inelastic commodity, fuel tends to have consistent or increased demand, irrespective of price. On the supply side, there are a number of factors that can limit the quantity of oil available in the market place, many of which are independent of the price of oil per barrel. When analyzed in the context of worldwide requirements, limiting factors, and consistent demand, it is little wonder that this resource has such a high level of volatility, nor is it any surprise how much potential damage it can do to an economy.
Uncertain global economic and financial prospects underpinned volatile oil futures prices over the last two months. West Texas Intermediate (WTI) and Brent followed divergent paths, with the price spread hitting record levels of over US$27/bbl earlier this month. The key difference between the two prices is that there is limitd pipeline capacity to the Gulf Coast, while there is adequate capacity to the Midwest. The International Energy Agency (IEA) has revised global oil demand down by 0.2 mb/d for 2011 and by 0.4 mb/d for 2012 on lower non-OECD readings and reduced economic growth expectations. Global GDP growth is now seen at 3.9% in 2011 and at 4.2% in 2012 with significant downside risks. Demand estimates now stand at 89.3 mb/d in 2011 (+1.0 mb/d y-o-y) and 90.7 mb/d in 2012 (+1.4 mb/d y-o-y).
August OPEC crude oil output was up by 165 kb/d, to 30.26 mb/d with production still 1.04 mb/d below the 31.3 mb/d estimates. Output for Q4 2011 has been lowered by 0.2 mb/d to 30.5 mb/d, due to weaker demand. With the end of Libya’s civil conflict on the horizon, the IEA has revised upwards its Libyan capacity outlook for Q4 2011 by 0.1 mb/d, to 0.3 mb/d.
OECD industry oil inventories rose by 10.8 mb to 2,687 mb, or to 58.4 days of forward demand, in July. Stocks fell below the five-year average for the first time since the economic recession of 2008. Preliminary data indicate OECD stocks remained tight in August, rising by a modest 0.6 mb.In the short-run oil prices are expected to fall on concerns that economic growth will slow in the U.S. and China, the fuel’s top two consumers.
The Federal Reserve this week cited “significant downside risks” to the U.S. economy and said it will replace $400 billion of short-term debt with longer-term Treasuries in an attempt to spur growth. A report yesterday showed manufacturing in China may shrink for a third straight month in September, the longest such contraction since 2009. The biggest threats to our fuel price remain significant supply disruptions, the resumption of rapid growth of the global economy leading to a substantial increase in demand and any meaningful weakness of the N$ versus US$.
Economist Ngoni Bopoto is The Oracle.