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Case Galloping Oil Prices Supply-Demand Dynamics

Case Galloping Oil Prices Supply-Demand Dynamics

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05/11/2014

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Galloping Oil Prices: Supply-Demand Dynamics
“Crude oil prices have become detached from the dynamics of supply anddemand”
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 - HE Abdalla Salem El-Badri, Secretary General, OPECIf there is one commodity that has the power to propel the global economyforward or bring it to a grinding halt, it is crude oil. Crude oil, rightly dubbedas ‘black gold’, plays a vital role in the production and distribution of a largenumber of products that are being used everyday either directly or indirectly.Its use is indispensable in transportation. It impacts the prices of fruits,vegetables and other food items because of the transportation cost involvedin moving them from one place to another. It is used as energy input forheating domestic and industrial buildings and as lubricant for engines andmachines. Viewed as a source of energy, the percentage share of oil in thetotal world energy mix was about 36.4%
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in the year 2005.Apart from its all-encompassing use, the importance of oil stems from thefact that oil is a non-renewable finite resource. The absence of an affordablealternative source of energy makes oil a highly volatile commodity in theworld market. Fluctuations in the demand, supply and price of oil can havefar-reaching consequences on the functioning of the global economy. Theprice of oil indirectly determines the price of almost every other commodity. The price of oil has been rising steeply since 2003 and it reached a high of $147 per barrel in July 2008
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. The rise has brought into focus the factors thatcontribute to an increase/decrease in the price of oil. It has been argued thatunlike other commodities, the pricing of oil does not always comply with thelaws of demand and supply. A complex combination of macro-economic, geo-political and environmental factors plays a crucial role in determination of theprice of oil.
Oil Crisis: Supply-Demand Dynamics
 The largest markets for crude oil are situated in London, New York andSingapore. But crude oil and its by-products are traded all over the world. Thequality of crude oil is determined on the basis of its specific gravity andsulphur content which in turn depends on the place from where it has beenextracted. The density of the crude will decide the level of processingrequired to refine it. Crude oil with less density and lesser sulphur contentwill require a simple distillation whereas heavier crude with higher sulphurcontent will require additional processing to produce the end product. The
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Laird Kerry, “OPEC: Oil Market 'Detached' from Supply and Demand”,http://www.rigzone.com/NEWS/article.asp?a_id=60651, April 21
st
2008
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Hussain Ali, “Security Of Oil Supply And Demand And The Importance Of The“Producer-Consumer” Dialogue”,http://www.mees.com/postedarticles/oped/v49n50-5OD01.htm, December 11
th
2006
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“Price of oil spikes to almost $147 and then drops”,http://www.iht.com/articles/2008/07/11/business/11oil.php, July11
th
2008
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difference in the cost of processing various types of crude oil will have animpact on the price of the end product. Apart from the cost of processing,factors such as the cost of transportation of crude oil from the producing fieldto the refinery and from the refinery to the consuming market, cost of storageand distribution, market conditions, etc also play a vital role in arriving at thefinal price of petroleum products.As there are too many varieties and grades of crude oil, the benchmark ormarker crude system was introduced in the mid-1980s for the sake of convenience in trading and pricing of crude oil in the international market. The price of the benchmark crude oil is taken as the baseline price on thebasis of which the price of other varieties is fixed according to their quality inrelation to the benchmark. Dubai crude is used as the benchmark in the gulf region. West Texas Intermediate (WTI) is the benchmark used in the UnitedStates. The New York Mercantile Exchange quotes the price of light, sweetcrude oil which has a sulphur content of less than 0.5%. If the sulphur contentis more than 0.5%, the oil is said to be sour. Another popular benchmark isthe OPEC basket price which takes into account the average of 15 differentcrudes from member countries which include the Saharan Blend from Algeria,Girassol from Angola, Oriente from Ecuador, Minas from Indonesia, IranHeavy, Basra Light from Iraq, Kuwait Export, Es Sider from Libya, Bonny Lightfrom Nigeria, Qatar Marine, Saudi Arabia's Arab Light, Murban from theEmirates and BCF 17 from Venezuela. Brent blend crude oil from the NorthSea sold at London's International Petroleum Exchange is generally acceptedto be the world benchmark. Although there are different benchmarks, theprice difference among them is very minimal and the price of crude oil ismore or less the same in all the markets
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.Like any other commodity, oil is also prone to frequent price fluctuations.Because of certain unique characteristics of the oil market, it is difficult toascertain the actual cause of such fluctuations at any given point of time. Therecent upsurge in world oil prices has set in motion a hot debate overwhether or not the price hike is the result of a mis-match between supply anddemand conditions. Some Economists are steadfast in their view that therecent swell in oil prices is indeed the result of the existence of a gapbetween supply and demand factors. According to them, when the price of oilreaches a point which the market will no longer be able to bear, demand willautomatically come down. This in turn will bring down the price paving wayfor equilibrium in the market. Oil market experts, on the other hand, claimthat the disparity between theory and practice is too wide in the case of oiland hence oil is an exception to the rule and does not always obey the lawsof demand and supply. The pages of history are replete with instances thatsupport their contention.
Formation of OPEC:
Before 1960, the production and distribution of oil inthe world market was largely controlled by the ‘Seven Sisters’. Seven Sistersis a term coined by the Italian oil magnate Enrico Mattei to refer to the seveninternational oil companies comprising of Standard Oil of New Jersey, Royal
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“Oil markets explained”, http://news.bbc.co.uk/2/hi/business/904748.stm, October18
th
2007
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Dutch Shell, Anglo Persian Oil Company, Standard Oil of New York, StandardOil of California, Gulf Oil and Texaco who dominated the world oil market
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. The developing countries who were the owners of the oil reserves had verylittle say in the affairs of business. The Seven Sisters decided the rate of return that could be enjoyed by these countries. In order to protect theirinterests and assert their position as owners, five oil producing countriesnamely, Iran, Iraq, Kuwait, Saudi Arabia and Venezuela came together to formthe “Organisation of Petroleum Exporting Countries” (OPEC) in the year1960
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.
 
OPEC was created with the objective of achieving price stability in theoil market by adjusting output according to market requirement and at thesame time ensuring that the oil producing countries get a fair rate of returnfor their investment. Other oil producing nations joined OPEC as members insubsequent years
(Exhibit I).Exhibit IMembers of the Organisation of Petroleum Exporting CountriesCountryJoined OPECLocation
Algeria1969AfricaAngola2007AfricaEcuador(**)rejoined 2007South AmericaIndonesia1962AsiaIR Iran*1960Middle EastIraq*1960Middle EastKuwait*1960Middle EastSP Libyan AJ1962AfricaNigeria1971AfricaQatar1961Middle EastSaudi Arabia*1960Middle EastUnited Arab Emirates1967Middle EastVenezuela*1960South America
*founder Members** Ecuador joined OPEC in 1973, suspended its membership from Dec. 1992-Oct. 2007
Source: Who are OPEC Member Countries?,http://www.opec.org/library/FAQs/aboutOPEC/q3.htm
Arab Oil Embargo:
When the Second World War came to an end, the Alliedforces created ‘Israel’ from out of the British-controlled territory of Palestine. The purpose was to provide a homeland to the millions of homeless Jews
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Nicholas Vardy A., “The New Seven Sisters: The World's Most Powerful OilCompanies”, http://www.theglobalguru.com/article.php?id=110&offer=GURU001
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“Brief History, The Organization of the Petroleum Exporting Countries (OPEC)”,http://www.opec.org/aboutus/history/history.htm
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