Crude oil is a major component of modern lifestyle. It has played an important role in many world events for over a hundred years. Wars have been fought over crude oil, and energy security is one of the major concerns of our economies. Unexpected oil price volatilities have been changing over time. In the early years, oil price shocks stemmed from oil supply disruptions possibly causing subsequent recessions (Noguera 2017).
The OPEC Market Structure
After its foundation in 1960, the Organization of the Petroleum Exporting Countries (OPEC) started a slow takeover of the crude oil market. By 1970, although the West Texas Intermediate (WTI) was priced roughly the same price as ten years before, the market started sending signals of shortage. By September 1973, the spot price was above the posted price, although the Seven Sisters were insisting on pushing the posted price down. In October of 1973, the Yom Kippur War and the Arab embargo to the U.S. and the Netherlands struck the market. Panic spread and the Shah of Iran decided, for the first time, to conduct an auction of some of the Iranian crude oil. The Sisters unsuccessfully tried to stop the bidding. Bids reached 17 dollars per barrel. In Nigeria, in another auction, there was a bid of $22.60 a barrel. It was now all too evident that the posted price was too low. The Sisters’ game to lower prices was discovered and the crude oil price quadrupled in a month. The price increases were followed by the wave of nationalizations of the 1970s.
During the 1970s, many new fields were also discovered, and many new participants entered the market. Crude oil was discovered in Brazil, Canada, the North Sea, Alaska and several African countries. After the fall of the USSR, several of the former Soviet republics also became major players. All that made the international petroleum market change its market structure once again. Currently, OPEC countries supply about 40% of the international crude oil production and control 81% of crude oil reserves (Noguera 2017).
Moreover, structural shocks to growth in non-OPEC oil production make a large cumulative contribution to growth in OPEC oil production. The reverse does not hold. The effect of shocks to growth in non-OPEC oil production on cumulative growth in OPEC oil production is larger over different periods such as 1974–1996 than over 1997–2012. Shocks to growth in OPEC oil production make large cumulative contribution to change in real oil price and vice versa. Shocks to growth in non-OPEC oil production do not make a large cumulative contribution to change in real oil price and vice versa.
During the “the age of OPEC”, growth in OPEC oil production can be predicted by growth in non-OPEC oil production and growth in global economic growth, and that during the “new industrial age” period, growth in OPEC oil production can be predicted by change in real oil prices and growth in global Gross Domestic Production (GDP) (Ratti and Vespignani 2015).
Like demand, supply and technology trends shift in unprecedented ways, new connections are being made in the world of energy (International Energy Agency 2018a). Between June 2014 and January 2015, oil prices dropped by at least 50%, mirroring the 1986 oil price drop. Both the 1986 and 2014 adverse oil price shocks were due to excess supply, as is the case with the current price war (Razek and Michieka 2019).
Oil prices vary depending on supply, demand and inventory:
OPEC production is centrally coordinated and controlled primarily by national oil companies (NOCs), whereas non-OPEC production activities are performed mainly by international investor-owned oil companies (IOCs) that operate independently. IOCs consider economic factors when making investment decisions, with the goal of increasing value for shareholders; hence, their investments and future supply levels are principally functions of market conditions. Although some NOCs have the same objectives as IOCs, NOCs’ objectives also include building infrastructure, increasing revenues and providing employment to benefit their economies. Low-cost conventional oil resources are largely found in OPEC member countries, whereas high-cost unconventional resources that are relatively hard to find and difficult to process tend to be found in non-OPEC economies (Alberta Energy 2019).
OPEC is an important driver of oil prices because it sets targets to manage oil production. Historically, oil prices rise when OPEC decreases production targets. OPEC exports comprise approximately 50–60% of aggregate global crude oil exports. This market share grants OPEC an influential role in the global oil market. Projections of OPEC production changes (particularly in Saudi Arabia) trigger changes in oil prices, reflecting the role of expectations in driving oil prices. Unexpected outages, the duration and extent of disruption, and associated uncertainty affect oil prices. Historically, geopolitical events in the OPEC region have resulted in supply disruptions. Hence, events that have actual or anticipated negative effects on supply greatly affect oil prices (Energy Information Agency 2018).
Exogenous factors, including wars and crises, influence oil prices by creating uncertainty about future oil supply and market conditions. OPEC adjusts production to changes in market conditions with a lag to ensure it is responding to permanent rather than transitory shocks (Kilian 2009).
Spare capacity, “the volume of production that can be brought on within 30 days and sustained for at least 90 days” (EIA 2018a), reflects the ability of global oil markets to react to possible oil supply disruptions, and OPEC’s efforts to push prices upward. Historically, Saudi Arabia had the largest spare capacity, which it maintained at 1.5–2 million barrels per day to manage the market (Razek and Michieka 2019).
Non-OPEC countries are located mainly in North America, Eastern Europe, and the North Sea. Non-OPEC countries presently account for approximately 54–60% of global oil production. Non-OPEC producers typically are price takers, and thus produce at or near full capacity with limited spare capacity. An increase in non-OPEC production causes prices to decrease, and a decrease in non-OPEC production causes aggregate global production to decrease. This intensifies demand for production from OPEC, increasing OPEC’s upward influence on prices. Compared to OPEC, non-OPEC production is more expensive because it occurs in remote areas (e.g., deepwater offshore sites), and requires unconventional approaches (e.g., oil sands extraction techniques). Hence, non-OPEC producers have ventured into developing new technologies to make products that command higher prices in the short term and decrease production costs (and consequently prices) in the long term. In addition, non-OPEC natural gas production has resulted in an increase in aggregate global liquids, including the supply of natural gas liquids (NGLs), alleviating the upward pressure on prices. Unexpected supply disruptions create uncertainty, which in turn increases price volatility. Overall, oil prices respond to changes in non-OPEC physical and expected production (Razek and Michieka 2019).
Oil consumption has declined in the Organisation for Economic Co-operation and Development (OECD) countries but increased substantially in non-OECD countries. The increase in oil consumption is driven by current and expected economic growth, as well as energy policies that have been implemented in some non-OECD countries to subsidise end-use prices (EIA 2018a). Such policies inhibit the responsiveness of consumption to changes in market prices and increase the extent to which economic growth drives demand. Many non-OECD economies tend to be driven by the manufacturing sector, which uses oil as a fuel and is more energy-intensive than the services sector. In the transportation sector, commercial and personal oil use and vehicle ownership per capita also increase as economies expand and incomes increase. Together with high population growth, these factors reflect the importance of non-OECD countries in driving oil prices (Razek and Michieka 2019).
In contrast, even when economic growth is strong, growth in oil consumption tends to be slower in many OECD countries, largely due to policy differences. For example, because OECD countries tend to provide fewer subsidies, consumers tend to respond faster to changes in market oil prices (EIA 2018a). Also, many OECD countries have implemented strict fuel economy standards for new vehicles and policies that support the use of biofuels, thereby limiting consumption growth. These differences are structural as well, as the services sector tends to be larger than the manufacturing sector in OECD countries (EIA 2018a).
Inventories are maintained to mitigate uncertainty about supply and demand. Refineries and storage terminals are used to store crude and other petroleum products to smooth the impacts of seasonal fluctuations, unexpected weather events, and refinery maintenance periods (EIA 2018a). In addition to commercial inventories, many countries such as the International Energy Agency (IEA) members maintain strategic petroleum reserves so they can respond to emergencies. Inventories satisfy current and expected demand and hence respond to the relationship between current and expected oil prices. If expectations suggest a relative increase in future demand and a decrease in future supply, the value of future oil contracts (and in turn, inventories) increases, creating a contango effect. A negative shock to current supply associated with a positive unexpected shock to current consumption would cause spot prices to increase relative to future prices, and inventories to be utilized to satisfy current demand, creating a backwardation effect. Also, if future prices are higher than current spot prices, there is an incentive to accumulate oil and sell it later at higher expected prices (Razek and Michieka 2019).
Increases in inventories could signal excess supply to market participants, which would cause spot prices to decrease in order to rebalance supply and demand. Therefore, the relationship between inventories and prices is bi-directional. Physical inventory levels and price spreads serve as signals that balance current and future prices as well as supply and demand, thereby creating an important link between financial markets and corporations with vested interests in oil (EIA 2018a). However, it is important to note that inventory data for major oil producers often are not made available on a timely basis, if at all. Moreover, crude oil is sometimes stored in sea vessels. This lack of information contributes to uncertainty, affecting the market and oil prices (EIA 2018a).