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POV : It is not the supply-demand that determines oil's price but the speculation in Commodities market?

By , ,
Industry : ONG

In one of his interview to media, former petroleum minister Mani Shankar Aiyar made an interesting observation when he remarked that since 2004, when he became the minister, oil prices have not been determined by supply and demand, but through speculation at the commodity exchanges like New York Mercantile Exchange (NYMEX). According to Aiyar, supply and demand plays a very small role in determining oil prices in comparison to speculation.

Infraline Energy speaks to oil and gas industry's stalwarts to find out what determines crude oil prices and how big a role speculation plays in determining the oil prices.

Deepak Mahurkar,Associate Director - Energy, Utilities & Mining: Oil and Gas,PwC

With the global economy experiencing inflationary pressures, the recent rally in crude oil prices could serve as catalysts for the increasing inflationary pressures. After remaining steady near US$80/bbl in January 2010, the crude oil prices climbed to $95/bbl in January 2011, followed by US$115/bbl/bbl in April 2011 and hovering above the US$100/bbl since then.

Historically, in 2008, when the oil prices breached the psychological barrier of US$100/bbl for the first time, rising past $120/bbl and beyond, this upward surge in prices was prima facie attributed to speculation by oil traders. With crude oil prices climbing in recent months, oil pundits and analysts are again alleging the role of speculators in driving up the price of crude. Thus, the moot question, which is yet to be answered, is it only speculation and not fundamentals that is driving oil prices?

The answer is an unquestionable no. Broadly, the factors that explain rise in crude oil prices include crude oil demand in OECD and non-OECD regions, supply from OPEC countries and in non-OPEC countries, financial markets and geopolitical factors.

As time elapsed, an in-depth post facto analysis of the 2008 crude oil price rally reinforced the fact that it was indeed the fundamental factors of demand and supply that had contributed majorly to upward surge in the crude oil prices. The supply of crude oil was not enough to meet the burgeoning oil needs of rapidly growing Asian economies of China and India. The oil suppliers had failed to anticipate the strong global economic growth from 2002-2007, particularly that from non-OECD countries including China and India. The lack of OPEC spare production capacity and untimely cutbacks by OPEC at the end of 2006, which remained unreversed till 2007, were the key supply side factors influencing crude oil price increase. Over and above these, changes in the product specifications (low sulfur fuels), lack of spare refining capacity to handle heavy sour crude oil and subsidies on oil consumption in many rapidly growing countries in Asia and the Middle East were also some of the factors leading to a surge in crude oil prices.

With the global economy recovering from the recession in early 2010, the crude oil prices rose from US$80/bbl to US$95/bbl against the backdrop of huge global demand increase that took place in 2010. At the start of 2010, world demand was forecasted to grow by 1.4 mb/d (million barrels per day) with International Energy Agency (IEA) estimating a whopping crude oil demand of 2.8 mb/d. By end of 2010, world economic growth of five percent and coldest winter in 30 years led to an increase in crude oil demand. The French oil labour strike and China coal halt disrupted oil supply driving up crude oil prices. The events in Middle East and North Africa (MENA) region such as interruption in crude oil exports from Libya worth another 1.4 mb/d accounts for rise in crude oil prices in first Quarter of 2011.

The income elasticity of oil demand is quite strong. Rising incomes lead to increased oil demand for transport, heating and cooling, and producing goods and services. Going forward, the oil consumption among the countries in the non-OECD especially India and China is expected to remain strong in the wake of the economic activity in these countries expected to remain strong. With one third of the world's population just entering the middle class, they aspire for a lifestyle which is oil-consuming.

The impact of supply side factors cannot be ignored. Saudi Arabia, the world's biggest producer of oil produces about 40 percent of the world's oil. Saudi Arabia's spare oil capacity is expected to be lower than widely believed, thereby, triggering price spikes in the months ahead. The Libyan crude is a very low-sulfur crude, which is in high demand for light products and is hard to replace without some logistical changes by Saudi spare capacity, which is higher in sulfur content. Saudi Arabia, the world's biggest producer of oil, produces about 40 percent of the world's oil. Saudi Arabia's spare oil capacity is expected to be lower than widely believed; thereby, triggering price spikes in the months ahead. Saudi crude cannot be a perfect substitute for the Libyan crude, as it is a very low-sulfur crude and is in high demand for light products thereby making it hard to replace without some logistical changes by Saudi spare capacity which is higher in sulfur content.

The demand and supply of oil are inelastic with respect to price changes. The demand is inelastic as there is a time-lag involved in altering the stock of fuel-consuming equipment and supply is inelastic in the short-run because it takes time to augment the productive capacity of oil fields.

Beyond the price elasticity, there is a factor of speculation in stock market. Any commodity when it is traded as stock in a market possibly gets dissociated with the generic market forces like demand or supply. To a trader, it is no longer a product or it offers much beyond the attributes of just a product. It is seen as a means to multiply investments and due to this reason is the dissociation from the product market trends. It turns out to be a commodity, which is indexed in a market where the forces are speculation driven.

Speculation is not always reasonable and thus not always directly related to business generics. The downside is that the end user of oil is also affected by the speculation at NYMEX, which is way too farfetched for him, like an unknown war or production disruption in a remote part of the world hitherto unknown to him. There is no fine line, where the supply demand dynamics in oil price makes way to the market speculation driven prices. These are component variables existent in any market and for any product. Larger the market, more universal the consumer network, deeper the market interdependence in the form of export or import, impact of just supply demand dynamics gets diluted and makes way for speculation driven pricing.

N C Sridharan,Former Director (Finance),Chennai Petroleum Corporation Limited (CPCL)

As far as supply-demand of oil is concerned, it more or less remains the same. There is not much movement on this front. And, geographically, supply-demand gets affected only at places where, say a, refinery has been shut-down. However, at the same time, there would be places where the capacity would be going-up. A case in point at present being Asia. If we take the oil consumption of Asia over the past six-seven years, it has more or less remained same. The only change that is discernible is when we look at per day consumption of oil. Here, too, apparent change in supply and demand of oil is very small. Over the past six-seven years, supply-demand has witnessed a change of mere two to three percent. At present, the per day consumption of oil stands at 87 million barrels a day, up from 84-85 million barrels a day in 2004-2005.

Thus, with both demand and supply moving in tandem, there is nothing that can be termed as oversupply or undersupply. Therefore, at best, demand and supply has an impact on oil prices only to the tune of five percent. Also, to put things in perspective, we need to track oil prices since 2004. From 2004 onwards or even a little earlier, the crude was oscillating between US$30 in 1990 to end up at US$20 in 1999-2000. In the intervening period, the crude price went down as low as US$12 barring 1998-99. Here, I am talking about Dubai oil. A decade ago, the differential between Brent crude oil and NYMEX was only US$ two to three. So, between the two, there was not much of a difference. Subsequently, over the years, the price differential between Brent crude oil and NYMEX has been steadily increasing.

Since 2004, on account of commodities trading - commodity prices have been going up with speculation playing a big role. And this was the first trigger point for oil prices to go up because by this point of time, 25 percent of commodities was on delivery basis and the remaining 75 percent was on speculation basis. Over a period of time, especially over the past two years, the next evolutionary landmark in oil prices came in 2010 when the terror premium got added to the price mix. However, all these years, the demand and supply worldwide continued to be the same with only geographical redistribution.

In-between with emerging signs of financial collapse of markets in 2008, the parity between currencies including Rupee, Dollar and Yen experienced terrific change. Crude oil price turned out to be very sensitive to these changes. A typical example of this change can be gauged from the fact that when forex rate was Rs 45, crude price was around US$60. When forex rate fell down to Rs 40 in 2007-08, on an average, the crude oil price went up to Rs 77. Now also, there is lots of currency parity interference in the past few months. Besides oil, the prices of other commodities have also been rising. Strangely, we still compare the crude oil prices of 1990s and 2000s. But at the same time, we do not compare those commodities, which were not traded earlier and then came into trading in exchanges; again those commodities that are already being traded and again get hyped.

The fact is that the base rate and benchmark rate for metals and other commodities has gone up considerably in the past few years. The basic example is metal and gold. And energy is not an exception to it, unless we go for other sources of energy, which are hard to find. Worldwide phenomenon and components of crude baskets are now very finely split into proper cost of crude, plus the inventory level, plus currency exchange parity between one country and the other.

Another point that we should bear in mind is that as far as crude oil prices is concerned along with the exchange parity, the problem of speculation is slightly taking a backseat. What was a major phenomenon in 2004-2006 gave way to terror premium in 2008 and the terror premium also appears to be fading in the post Osama-Bin-Laden world. Another recent and unique phenomenon and development relates to the fact that now Brent crude oil is quoting US$20 more than NYMEX. Earlier the difference between the two used to be about US$ five to seven. It's a recent phenomenon and is unique and has been brought out of US recession. Due to a poor show by US, the Brent oil is predominantly high and Dubai oil is always catching up.

In the past, Brent oil and NYMEX differential used to be only between US$ two and three. This difference has been hovering between US$ six and seven for the past two years. However, since 2011 the difference between the two has been to the tune of US$ 20 which is very abnormal and shows the severity with which US recession is impacting the global economy and oil prices as well.

The real uncertainty in global scenario with closure of some of the refineries for the purpose of converting these into terminals coupled with poor performance by small economies in European countries together exercises an impact on crude oil prices. Also, European countries are more concerned about their inventory shortage, when it comes to making crude oil available at short notice. Of late, the US economy is also not picking up and the unemployment rate is going-up. Things are further complicated by regular occurrence of natural calamities such as hurricane hitting the country every year.

These are various components, which have made crude oil prices very-very dynamic. These components have too many ponderables - factors seasonal and non-seasonal; again the quality of crude with more refineries coming for high sulphur crude processing--no wonder NYMEX crude is receeding.

Mrinal Madhav,Assistant Director (IC),Petroleum Planning and Analysis Cell, Ministry of Petroleum and Natural Gas

It would not be correct to mention here that stock market alone determines oil's prices and not the supply-demand. Hence I choose to oppose this motion.

Today, one of the most heavily traded commodities in the world is oil .The price of crude oil is derived and is based on several important factors like: overall supply/demand for crude, supply/demand for petroleum products, freight rates, competition in the crude markets, competition in the regional and domestic markets for petroleum products.

There is also an element of the stock exchanges, which does influence the crude oil prices. Stock exchanges do play an important role in crude oil price, but compared with other factors, which help in deciding the crude oil prices, stock exchanges may not be considered as the sole deciding factor in crude oil prices.

On the stock market, crude oil is mainly sold through various contract arrangements apart from spot transactions. As a mechanism to mitigate risk, oil is also traded on futures market, but this is not to supply the physical volumes of oil.

Since early 1990s, there has been a greater amount of transparency seen in deciding the crude oil prices. This is mainly done by the use of benchmarking/marker crude oils:

  • West Texas Intermediate (WTI - USA)

  • Brent (Europe, Africa and Asia)

  • Dubai and Oman (Middle East)

  • Dubai, Tapis and Dated Brent (in Asia-Pacific)

A futures contract for crude oil is a promise to deliver a given quantity of crude oil, but this rarely occurs as participants are more interested in taking a position on the price of the crude oil. Futures markets are a financial instrument to distribute risk among participants with the side effect of providing transparency on the pricing of crude oil.

It's interesting to note the fact that, nearly two thirds of global crude oil production is consumed by the leading industrialised countries - i.e., the countries that make up the Organisation of Economic Cooperation and Development. But a rising share of oil demand is coming from the emerging market economies including China, Brazil, Russia and India. This leads to a very interesting situation per se global consumption v/s demand scenario.

The supply of oil can be categorised into short-term supply and long-term supply to international markets. Short-term oil supply is mainly from the known source of oil reserves, also as production gets closer to capacity limits, this short-term supply tends to erode.

The element of profit motive (quantum of production decided by OPEC and non-OPEC countries), inventories at the refinery premises (in case of rise in demand fluctuation in market, the large inventories by refineries can be released) and external shocks like production loss due to natural disasters, rig closure, etc, influences the crude oil prices to a great extent in short- term supply.

Long run world oil supply and its prices are mainly influenced to a great extent by the reserves of oil field (faster the demand grows, the quicker the expected rate of depletion), newer ways and areas of exploration (it makes financial sense to invest more resources in exploring for new reserves, even though these may not come on stream for some years) and the kind of latest technologies being implemented in oil extraction.

The role and impact of the cartel

In international oil market, the role of cartel in the form of Organisation of Petroleum Exporting Countries (OPEC) is always considered to be critical. With around 40 percent of current world supply capacity, OPEC plays a pivotal role in shaping the direction of oil prices. It's also equally important to highlight the fact that when the cartel acts together to control production and balance supply and demand in the international market, non-OPEC countries account for the largest portion of total supply and gets an opportunity to push more oil in the market due to no quota on non-OPEC countries.

With the recent turmoil and changing dynamics in global oil industry, it's a foregone conclusion that the era of cheap oil has gone, and we need to be prepared for paying higher crude oil prices.

Frequent volatility in oil prices is very dangerous for producers as well as consumers. The fluctuation in oil prices has a cascading effect on several other sectors, which depend on oil as the key input for their source of energy.

Recent geo-political events, change of regimes in mostly oil producing countries, the fast pace of development and the rising demand of oil in developing countries has also established strong indication to the fact that there is lot more factors, which influence the crude oil prices than the stock markets.

(InfralineEnergy thanks Dipesh Dipu, Chandra Bhushan and Coal India Ltd. for sharing their insights. Infraline introduces "Points of View" as an initiative for encouraging dialogue between various stakeholders of the Indian energy sector on contemporary subjects. If you wish to participate in such initiative, please write to

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