INDIVIDUAL PROJECT: OIL PRICES CASE – Report Two

INDIVIDUAL PROJECT: OIL PRICES CASE – Report Two

ECO 100 – Introduction to Economics

Report TWO

Introduction

Oil is one of the most essential commodities in the contemporary world’s economy. The world crude oil price path can be explained through the use of supply-demand and other macroeconomic factors (Mitchell, 2002; Yergin, 1992). For example, supply side, expectations that have an effect on world oil prices include the uncertainty relating to the future production capacity and the physical availability of crude oil supply (Fattouh, 2007; Kilian, 2008; Hamilton, 2009). In addition, uncertainty linked with unexpected shortfalls of available supply relative to the expected levels of oil demand on the demand side result in price changes (Hamilton, 2013; Kilian, 2009). Thus, the supply and demand factors are associated with the oil price shocks that reflect disruptions in oil production. Following the 1970s oil crisis, the crude oil industry experienced fluctuations in real oil prices.

There are two-fold objectives in this report:

1. to discuss the oil price fluctuations from 2012 until the end of 2016, and
2. to provide predictions of the oil prices for the next five years (2017-2022).

The Oil Price Fluctuations from 2012 until the End Of 2016

Global oil demand and supply are the prime factors associated with the fluctuations in oil prices (Hamilton, 2009). Nonetheless, both the demand and supply of oil are influenced by short as well as long-term factors. The short-term factors include political conflict, exchange rate fluctuations, speculative trading, and natural hazards (Okullo, 2013). The short-term factors induce momentary spikes in oil prices, whereas long-term factors resulted in gradual shifts in the levels of prices. Between 2010 and 2014, the oil prices were stable, but they halved and decline to less than $50 p/b by the third quarter of 2014. The decline was linked to reduced demand and increased supply of oil prices. According to Aimer (2016), “The price of a barrel of Brent crude oil in European countries fell from than $100 p/b in Sept 2014 to less than $46 p/b in January 2015” (p. 17). The excess capacity in terms of available oil produced, coupled with precautionary demand shock and strong supply and stagnant demand was responsible for the decline in oil prices between July 2014 and January 2015 (Coleman, 2012; Economou, 2016).

Demand and supply factors have been responsible for the decline in oil prices since 2014 (European Central Bank, 2016). For example, the initial decline was associated with supply increases, which accounted for 60% of the 2014 decline. Nonetheless, demand factors played an increasing role in the decline of oil prices in 2015.  This reflects a slowdown in aggregate demand. However, lower price expectations and speculations were associated with growth in emerging markets, and this compelled OPEC not to cut supply resulting in a decline in oil prices (European Central Bank, 2016). As indicated in figure 1, since 2014 the OPEC supply trended upwards, whereas oil demand from non-OECD countries was stable, and Oil demand from OECD countries decreased during the last quarter of 2015, then the oil prices declined also. Low demand as a result of winter and increased supply by OPEC between 2014 and 2015 was responsible for the increase.

Figure 1: World oil supply and demand: Source: (European Central Bank, 2016).

Figure 2 below illustrates the price pressure of oil prices between 2012 and 2016. From Figure 2, the price of oil has been affected by different factors including the effects of the 20008-2009 financial crisis. According to Russell (2016), in 2012, the price was about $120 a barrel, but it has since fallen by 60 percent to nearly $43 a barrel. This was associated with a stable economy around the world. Thus, the oil fluctuation between 2012 and 2016 was linked to geopolitical as well as economic turmoil. After the financial crisis, the demand for oil increased, while the supply increased also, hence increasing the prices. Nonetheless, the supply increased more than demand between 2014 and 2016, and this resulted in a decline in oil prices as illustrated in the figure below.

Figure 2: Balance of Supply And Demand. Source: Russell (2016).

When the demand for oil is high ceteris paribus, then the world price of oil must definitely increase (Tsoskounoglou et al., 2008). On the other hand, the decline in demand results to decline in world oil prices.  Thus, demand patterns such as changes in the population’s income, efficiency, the number of uses of oil, and the price of substitutes resulted in stable oil prices between 2012 and the third quarter of 2014. Nonetheless, inflation and reduced demand in terms of oil consumption resulted in declining prices. Also, Substitutes for oil, including the use of natural gas and biofuels in developed economies influence the demand for oil, and this lowered the demand for oil, hence low prices (Asia Pacific Energy Research Centre, 2016; Okullo, 2013).

Predictions of the Oil Prices for the Next Five Years (2017-2022)

Based on the current economic environment across the globe accompanied by volatility and unpredictable macroeconomic factors, the prices of oil are more likely to increase. For example, as the world becomes more productive, the demand for oil is expected to increase against the uncertain oil supply, mainly from the Middle East. This prediction is in line with predictions made by the U.S. Energy Information Administration (201^) forecast that although volatility will be low, crude oil prices are likely to increase. For example, it is estimated that the average price in 2017 will be $55/barrel in 2017 and $57/b in 2018 (Amadeo, 2017). The increase in oil prices is linked to high demand, especially in developed countries. The prediction by the U.S. Energy Information Administration (EIA, 2016) is relatively closer to those provided by the World Bank as given in the figure below.

Oil Prices for the Next Five Years (2017-2022). Source: Knoema.(2017).

From the given above, the average oil price in 2017 will be $55/barrel in 2017 and $66/b in 2020. Between 2017 and 2022, the prices will continue to increase. The EIA has projected that the demand for oil to outstrip the supply by 2022, and this could result in increased prices. In addition, changes in crude oil supply and demand could lead to volatility in crude oil prices as illustrated in the figure above (Kristopher, 2016). Other factors such as political instability such as the war in Syria could have an impact on oil prices in the future, given that the Middle East is a major oil supplier to the world. The global picture of the oil prices shows a future whereby the current demand will not be satisfied by the available supply in the market.

Based on basic supply and demand rules, when the demand is higher than the supply, the prices of oil will possibly increase. On the demand side, the IEA’s report indicates that global oil demand is anticipated to grow by 1.2 million b/d on average each year to 2022. In addition, oil demand is expected to pass the 100 million b/d threshold in 2019, and reach an estimate of 104 million b/d by 2022 (Oil and Gas Journal, 2017). Also, developing countries’ accounts and emerging economies will also result in an increased demand for oil. On the other hand, the supply will not be able to meet the projected demand by 2022 unless investments are done or new oil explorations are established.  With the demand for oil outstripping the market supply, the price of oil will definitely increase.

The other factor associated with the increase in world oil prices between 2017 and 2022 is the constrained supply. According to the constrained supply perspective, the available conventional oil fields which account for 80% of the current supply are depleting rapidly. Arezki et al. (2017) estimated that the depletion rate of the oil fields is about 3 and 4 percent per year, which implies that significant new sources are required to supply oil supply and meet the growing demand. See the illustration in Table 1 below.

Table 1. World Oil Production: Source: U.S. Energy Information Administration. (2016).

Table 1 has showed that at present depletion rates, the already existing conventional oil fields are expected to decline in terms of oil supplied.  For example, the oil fields will decline from 68.3 million barrels of oil per day to approximately 44.6 million bpd by 2025. Subsequently, there will be a shortfall of about 23.7 million that will need to be provided to meet the demand. The decline in supply and an increase in demand is more likely to result in increased world oil prices.

Conclusion

Both demand and supply factors have an impact on the price of oil. For instance, between 2012 and 2016, oil prices decline (particularly between 2014 and 2016) and this was a result of exchange rate fluctuations, speculative trading, precautionary demand shock and strong supply and stagnant demand as well as the excess capacity of the available oil produced.  From 2017 onwards, world oil prices are more likely to increase because of a number of demand and supply factors. For example, the anticipated decline in oil supply as a result of depletion in existing oil fields, the increased demand that outstrips the supply, increased production, increased consumption in developing countries and emerging economies, and political instability in the Middle East could result to increase in oil prices between 2017 and 2022.

References

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