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Energy Systems

Name Index NO Date of Submission

:- A.G.N.Bandara :-090041G :-30/05/2012

Crude oil or its derivatives are closely linked with national economic development and the daily life of public, the yearly consumption of oil occupies about 40% of total consumption of global energy. But because of its uncertain supply and big price fluctuation, oil is a strategic fossil energy for all countries in the world. The twice widely happened oil crises in the 1970s has brought huge destructions to the worldwide economy. Since entering the 21st century, the international oil price fluctuates at a high level again, it seems that oil price has rocketed, from 49.51 dollars/barrel in January 2007 to 142.95 dollars/barrel in July, 2008, then dropped abruptly below 40 dollars/barrel in December, 2008 again. The international big oil price fluctuation has created dramatic changes for the oil and economic security in the world. Therefore, it is full of realistic directive significance to make a comprehensive and systematical review and analysis for all factors, which effect the international oil price fluctuation. To the basic factors that decide the international oil price, some scholars believe it lies mainly in the supply and demand . But in my opinion, behind the international oil price fluctuation existed not only the constantly self-adjust between supply and demand on the world crude oil market, but also the strength competition between nations, for this reason caused the diversity and complexity of the factors, which effected the international oil price fluctuation.

Historical fluctuations of crude oil prices in the world

The analysis of fluctuations in crude oil is more reasonable after 1945. Thats because on one hand, the oil industry before 1945 was still in its infancy, the technological level and mining capacity were far from mature, added to that a small proportion of oil consumption in the whole world energy consumption structure, which was far below the coal consumption share,the international oil price fluctuation had not big impact on the international balance of payment in the oil consumption countries; on the other hand, before the Second World War, the international oil market was leaded by several western transnational oil companies, in such a case, the oil price kept relative stability to some degree After the Second World War, most major consumption countries entered into the full construction period, together with the improvement of technological level and mining capacity of oil industry, caused the unprecedented enthusiasm of oil demand. By 1967, the proportion of oil in the world energy consumption structure surpassed that of coal finally, reached 40.4% and become the major energy in the world. Under this background, Organization of the Petroleum Exporting Countries (OPEC) began to establish as an important organization for energy cooperation between energy exporting countries. But during this period the pricing power in the international oil market was still owned by the western transnational oil companies, the members of OPEC didnt have important impact on the international oil price at the beginning of establishment, for this reason, the oil price kept relative stability at that time. From 1948 to 1960 s, the nominal crude oil price stayed at 2.50 to 3.00 dollars. But calculated the dollars exchange rate in 2004, from 1948 to 1957, the real crude oil price fluctuated intervallic at 15 to 17 dollars/barrel and 20% increasing was in line with inflation. From 1958 to 1970, the crude oil price dropped from 15 dollars each barrel to 13 dollars each barrel in real terms. From here we could see that the international oil price was only slightly adjusted in the small scope. As the oil production countries were exerting more and more influence on the international crude oil market day by day, the operating petroleum companies were nationalized by oil exporting countries, which was why the western oil companies gradually lost the control over the oil resources in oil producing countries. Especially in Teheran in 1971, some oil exporting countries reached a consensus to control the oil exporting through the abolishment of agreements with concession or further participating in the process of oil production or other means .In the oil consumer market, since the European and Japanese economic recovery in succession after the Second World War drove rapid growth of worldwide demands for oil and the most of them must be met by relying on the oil exporting in the Middle East, the Organization of Petroleum Exporting Countries obtained bigger words power

in the international petroleum market. Plus,with the establishment of dollar standard system and dollar as the pricing currency for petroleum, dollar links officially with petroleum since the year from 1974, any country, who wants to trade oil, has to reserve dollars and since then the fluctuation of dollar exchange rate has become one of the most important factors that effect the international petroleum price. The outbreak of fourth Middle East War in October, 1973 became the powder-hose of first oil crisis and provided the members of OPEC with a perfect opportunity to recovery the oil pricing power. The Arabian oil exporting countries laid an embargo of crude oil on the countries, who were behind Israeli, and reduced the crude oil production, which finally led to the daily production reduction of crude oil of 4 million barrels in Arabian countries (From October to December, 1973, the global petroleum supply dropped by 7%, in March, 1974, the supply was 5% lower than that in October, 1973), and the crude oil price in the international petroleum market increased for times, 3 dollars each barrel in 1972 surged above 12 dollars each barrel at the end of 1974, and the price has remained until 1979. According to the estimation from American economists, this oil prices soaring caused economic recessions generally in western countries, the U.S. GDP growth rate dropped consequently by 4.7%, the European by 2.5%, the Japanese by 7%. The Iranian Revolution in November, 1978 and the IranIraq War in September, 1980 resulted in the serious crippling of oil production capacity in Iran and Iraq directly. The oil-export in Iran dropped to 1 million barrels/day and by the forth quarter in 1980 the oil export was even completely stopped. The oil production in Iraq was from 3.5 million barrels/day before the war down to 500 thousand barrels/day at the end of 1980. The drastic reduction of oil production plunged the international oil market, whose clam was just restored, into a panic again, the crude oil price in spot market rose steeply with the sharp reduction of production, from 31 dollars/barrel before the war up to 40 dollars/barrel in the first ten-day period of December, which resulted in the second oil crisis. After this oil crisis the international oil price experienced a relatively long-term falling. Until August, 2, 1990, due to the Iraqi invasion of Kuwait, the United Nations laid a total embargo of oil exporting on Iraq and Kuwait. Outbreak of Gulf War and Embargo of the United Nations led directly to daily reduction of crude oil supply by 4.7 million barrels in the international oil market, which occupied 7% of the global aggregate demand at that time. The following international oil price rose in as little as three months from 14 dollars each barrel to 40 dollars. However, thanks to the timely increased production in OPEC countries, the supply shortage of this oil crisis was quickly supplemented; besides the international energy institution started the emergency mechanism promptly, the member countries exchanged information and coordinated policies each other, which stabilized the market, avoided collective panic buying in the crude oil market and pulled the in- ternational oil price back quickly. So this oil crisis didnt last long and compared with the previous two crises, the fluctuation of international oil price brought by this crisis didnt have substantial impact on the world economy. After this crisis, the international oil price fell back to 15 to 20 dollars again. After 1996, with the recovery of oil exporting and the gradual production increasing in Iraq, especially the strong impact of the Asian financial crisis on world economy and oil demand in 1997, the international petroleum price dropped continuously and fell to 10 dollars each barrel at historically low levels in 1998. OPEC appealed to underproduction continuously, which triggered a slight re-bound of international oil price in 1999 and 2000, then because of the outbreak of 9.11 incident, the international oil price started a new round of huge increases. From 2002 on, since every country issued the tolerant economic policies in succession to boost their economic development, the global economy began to enter into a full recovery period, the global economy presented a positive state overall, the global GDP growth rate rose continuously from 2.6% in 2001 and stayed high all along. The economic resurgence brought the rapid increasing of crude oil demand, which caused the international oil price rose unceasingly and up to a record high price, nearly 150 dollars each barrel in the middle of the year 2008. However, because of the outbreak of financial crisis, in the second half of the year it dropped rapidly at the lowest level in recent years, to 40 dollars each barrel, by more than 100 dollars in just five months. Entering into 2009, it rose from more than 40 dollars to more than 70 dollars in short time

and the increase was even up to 70%.The below graph shows that the fluctuations of crude oil price is more significant after 170s.

important happenings in the world, which have affected major price fluctuations
Post World War II
Crude Oil prices ranged between $2.50 and $3.00 from 1948 through the end of the 1960s. The price oil rose from $2.50 in 1948 to about $3.00 in 1957. When viewed in 1996 dollars an entirely different story emerges. In 1996 dollars crude oil prices fluctuated between $14 - $16 during the same period. The apparent price increases were just keeping up with inflation. From 1958 to 1970 prices were stable at about $3.00 per barrel, but in real terms the price of crude oil declined from above $15 to below $12 per barrel. The decline in the price of crude when adjusted for inflation was further exacerbated in 1971 and 1972 by the weakness of the US dollar. OPEC was formed in 1960 with five founding members Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. By the end of 1971 six other nations had joined the group: Qatar, Indonesia, Libya, United Arab Emirates, Algeria and Nigeria. These nations had experienced a decline in the real value of their product since foundation of the Organization of Petroleum Exporting Countries. Throughout the post war period exporting countries found increasing demand for their crude oil and a 40% decline in the purchasing power of a barrel of crude. In March 1971, the balance of power shifted. That month the Texas Railroad Commission set proration at 100 percent for the first time. This meant that Texas producers were no longer limited in the amount of oil that they could produce. More importantly, it meant that the power to control crude oil prices shifted from the United States (Texas, Oklahoma and Louisiana) to OPEC.

Middle East Supply Interruptions

Yom Kippur War - Arab Oil Embargo In 1972 the price of crude oil was about $3.00 and by the end of 1974 the price of oil had quadrupled to $12.00. The Yom Kippur War started with an attack on Israel by Syria and Egypt on October 5, 1973. The United States and many countries in the western world showed strong support for Israel. As a result of this support Arab exporting nations imposed an embargo on the nations supporting Israel. Arab nations curtailed production by 5 million barrels per day (MMBPD) about 1 MMBPD was made up by increased production on other countries. The net loss of 4 MMBPD extended through March of 1974 and represented 7 percent of the free-world production. If there was any doubt that the ability to control crude oil prices had passed from the United States to OPEC it was removed during the Arab Oil Embargo. The extreme sensitivity of prices to supply shortages became all too apparent. Prices increased 400 percent in six short months. From 1974 to 1978 crude oil prices increased at a moderate pace from $12 per barrel to $14 per barrel. When adjusted for inflation the prices were constant over this period of time. Crises in Iran and Iraq Events in Iran and Iraq led to another round of crude oil price increases in 1979 and 1980. The Iranian revolution resulted in the loss of 2 to 2.5 million barrels of oil per day between November of 1978 and June of 1979. In 1980 Iraq's crude oil production fell 2.7 MMBPD and Iran's production by 600,000 barrels per day during the Iran/Iraq War. The combination of these two events resulted in crude oil prices more than doubling from $14 in 1978 to $35 per barrel in 1981. US Oil Price Controls The rapid increase in crude prices in this period would have been much less were it not for United States energy policy during the post Embargo period. The US imposed price controls on domestically produced oil in an attempt to lessen the impact of the 1973-74 price increase. The obvious result of the price controls was that U.S. consumers of crude oil paid 48 percent more for imports than domestic production. Of course U.S producers received less. Did the policy achieve its goal? In the short term the recession induced by the 1973-1974 crude oil price rise was less. However, it had other effects as well. In the absence of price controls U.S. exploration and production would certainly have been significantly greater. The higher prices faced by consumers would have resulted in lower rates of consumption: automobiles would have had higher mileage sooner, homes and commercial buildings would have been better insulated and improvements in industrial energy efficiency would have been greater than they were during this period. As a consequence, the United States would have been less dependent on imports in 1979-1980 and the price increase in response to Iranian and Iraqi supply interruptions would have been significantly less.

OPEC's Failure to Control Crude Oil Prices

OPEC has seldom been effective as a cartel. During the 1979-1980 period of rapidly increasing prices, Saudi Arabia's oil minister Ahmed Yamani repeatedly warned other members of OPEC that high prices would lead to a reduction in demand. His warnings fell on deaf ears. The rapid price increases caused several reactions among consumers: better insulation in new homes, increased insulation in many older homes, more energy efficiency in industrial processes, and automobiles with higher mileage. These factors along with a global recession caused a reduction in demand which led to falling crude prices. Unfortunately for OPEC only the global recession was temporary. Nobody rushed to remove insulation from their homes or to replace energy efficient plants and equipment -- much of

the reaction to the oil price increase of the end of the decade was permanent and would not respond to lower prices with increased demand for oil. From 1982 to 1985 OPEC attempted to set production quotas low enough to stabilize prices. These attempts met with repeated failure as various members of OPEC would produce beyond their quotas. During most of this period Saudi Arabia acted as the swing producer cutting its production to stem the free falling prices. In August of 1985, the Saudis tired of this roll. They linked their oil prices to the spot market for crude and by early 1986 increased production from 2 MMBPD to 5 MMBPD. Crude oil prices plummeted below $10 per barrel by mid-year. A December 1986 OPEC price accord set to target $18 per barrel was already breaking down by January of 1987. Prices remained weak. The price of crude oil spiked in 1990 with the uncertainty associated Iraqi invasion of Kuwait and the ensuing Gulf War, but following the war crude oil prices entered a steady decline until in 1994 inflation adjusted prices attained their lowest level since 1973. The price cycle then turned up. With a strong economy in the United States and a booming economy in Asia increased demand led a steady price recovery well into 1997. This came to a rapid end when the impact of the financial crisis in Asia was underestimated by OPEC. In December, OPEC increased its quotas 10 percent to 27.5 MMBPD but the rapid growth in Asian economies had come to a halt. If the EIA's crude oil price forecast is on target, this year will, on an inflation adjusted basis, surpass 1994 as the worst year for oil prices since 1973.

Change of the crude oil inventories in all countries.

Petroleum inventories include conventional inventory and unconventional inventory. Conventional inventory refers to the inventory, which can guarantee the worlds petroleum production, processing and supply system normal running. And unconventional inventory refers to the commercial inventory, which is mastered by the transnational oil companies. Although the conventional inventory occupies above 80% of the global crude oil total inventory, the impact of which is far smaller than the impact of unconventional inventory on the international oil price. In the long run, as the buffering between oil supply and demand, oil inventories in all countries play a stable role on international oil price. Normally when the oil price is low, all countries increase its oil inventories generally in order to push the oil price upward; in contrast, sell the oil in store when the oil price is high, in order to push the oil price down. In the short term, oil inventory plays an important role on the fluctuation of international oil price. The oil in store is often purchased in quantity when the international oil rises, which pushes the international oil upward in a short time .The reverse is possible. Thus it can be seen that the oil inventory has a very complicated impact on the international oil price, it cannot be judged according to the same standard.

Predictions of the crude oil prices for next 10 years based on the current economic and political trends in the world.

Economic trend In order to analyze the prices of crude oil in the future in the economic aspect. First and foremost we should consider the demand for the crude oil. Increment for the demand for the crude oil affects the crude oil price to increase according to theories of economics. The demand for crude oil can be categorized as mentioned in below.

Cyclical demand: There is a strong link between the demand for oil and the rate of global economic growth because oil is an essential input into many industries when the economy is expanding, the demand for oil rises. The best recent example of this is the growth of the Chinese economy. Fast growth of national output in energy-intensive sectors has led to a surge in demand for crude oil into the Chinese economy.There was a significant collapse in world economics during 2006-2009 period and the world economy is recovering from 2009.Now that the global economy is in recovering state the demand for crude oil will be increased. It can be said that the recovering state will last more than 10 years using past world GDP data.Therefor there is a trend in increasing the crude oil prices during next decade. Prices of substitutes: Demand for crude oil affected by the relative prices of oil substitutes (e.g. the market price of gas). If, in the longer term, reliable and relatively cheaper substitutes for oil can be developed, then we might expect to see a shift in demand away from crude oil towards the emerging substitutes. The high price of oil during 2004-2006 seems to have led to a rise in research and development into non-oil substitutes. These can take several years to come through to affect the market for energy. The prices of natural gas are decreasing continuously form 2009 because of research and new technology. Decrement of natural gas prices will decrease the demand for crude oil in general. In order to get a broad idea the price elasticity should be analyzed. Considering all these factors it can be said that there is a considerable influence from the natural gas price for the demand of crude oil prices. So in next decade there is a trend of decreasing crude oil price because of decreasing prices of natural gas. Changes in climate E.g. affecting the demand for heating oil. It is often said that if the winter in North America is fierce, then the price of crude rises as the USA and Canadian economies raise their demand for oil to fuel household heating systems and workplaces. The world temperature is increasing due to global warming. So the need of the heating oil will be less and the demand will decrease for crude oil which affects for decrement of the crude oil prices. Market speculation: There is always a speculative demand for oil (i.e. purchasers hoping for a rise in prices on world markets). Indeed one of the features of the most recent spike in oil prices has been the high level of demand by hedge funds and other investors pouring into the international petroleum exchanges to buy up any surplus oil futures contracts. They hope that by the time the contracts are ready to be fulfilled, they will have made a large profit. Speculation involves risk, prices can do down as well as up .the crude oil prices are increasing although there was small fluctuatios.So the demand for the crude oil will be decreased and forces to crude oil price to decrease .But this is short term incident. And this will make the fluctuations in crude oil price in next decade. By considering all above economic reasons the crude oil price will be increased but that will not be a price rocketing.

Political trend Crude oil is vital in this day and age. Countries in the middle-east such as Saudi Arabia have economic control over other countries such as Great Britain who do not have oil resources but desperately need it. Many invasions resulting in war have been because of the amounts of oil in the invaded country. In 19 March to 1 May 2003 was the start of the conflict known as the Iraq War, or Operation Iraqi Freedom, in which a combined force of troops from the United States, the United Kingdom, Australia and Poland invaded Iraq and toppled the regime of Saddam Hussein in 21 days of major combat operations. The invasion phase consisted of a conventionally fought war which concluded with the capture of the Iraq capital Baghdad by United States forces. Due to this Iraq invasion the production of crude oil was critically affected. But now the country is recovering and the crude oil production is increasing. Projections shows that the it will pass 12 mbpd (millions of barrels per day) at 2020.This is good sign the supply of the crude oil will be increased and therefore the demand will be decreased. This results the decrement of the crude oil price in the future. The Libyan civil war (also referred to as the Libyan revolution), was an armed conflict in the North African state of Libya, fought between forces loyal to Colonel Muammar Gaddafi and those seeking to oust his government. The war was preceded by protests in Benghazi beginning on Tuesday, 15 February 2011, which led to clashes with security forces that fired on the crowd. The protests escalated into a rebellion that spread across the country, with the forces opposing Gaddafi establishing an interim governing body, the National Transitional Council. Although there was a revolution the oil industry is quickly recovering the prewar production of crude oil is 1.6mbpd now it has reached to 1.55mbpd. Below figure shows a comparison of oil supply disruptions due to political and technical problems. That shows the crisis is not very much affected to crude oil industry. .

The analysis show that the political issues do not cause a long term issues in crude oil production although is causes short time price changes. But long term analysis shows a very significant figure that is the global production of crude oil is saturating proving that the crude oil is non-renewable resource but the demand will not saturate because the needs of the man is not limited. This is the signs of a future global fuel crisis. Further oil explorations and technical improvements are essential for survival. If it is not happened oil prices will increase with no doubts. Above economical political and long term economic analysis shows the increment of future crude oil prices. The future is uncertain but we should plan the future.