World Oil Price - Essay Example

?Running Head: OIL PRICE ANALYSIS Oil Price Analysis of the of the Oil Price Analysis The price of world oil has been extremely volatile in the past three decades. It was as low as US$2.17 a barrel in 1971 but spiked to US$34 in 1981, only to plummet to below US$10 in 1986. The price rose to US$50 in 2005 from under US$10 in late 1998 and early 1999. Oil prices hit a record high level of over US$145 a barrel in July 2008. With the onset of the worldwide financial crisis and deep recession, a reduced demand for crude oil drove down prices as it had done in the past, and the price of oil dropped to US$34 in February 2009, gradually increasing to US$80 in January 2010. Since the inception of the Organisation of the Petroleum Exporting Countries (OPEC) cartel in 1971, the modeling of crude oil pricing in the world market has been prolific. The world oil market is often said to be best described by four major models (Griffin,2002, 52): cartel, competition, target-revenue and property-right models. MacAvoy (2004) and Verleger (2007) claim that the oil price is largely determined by market fundamentals. Supply disruptions, rather than cartel-related actions, impact oil prices. As an alternative, Ramcharran (2001) supports the target-revenue model, claiming that oil production is determined by the OPEC countries' ability to absorb internal investments from oil revenue. From the viewpoint of the Hotelling theory with zero extraction cost, the property-right models indicate that the real price of oil will rise at a lower discount rate as host countries take over the ownership from oil companies (Johany, 2005, 352). However, the most popular version is a cartel-related model of Adelman (2004), which contends that OPECs behavior lies between market-sharing-cartel and dominant-firm models. In a well-known paper, Griffin (2002) tests the four models that attempt to describe OPECs behavior. Using quarterly data from the first quarter of 1971 to the third quarter of 1983 for 11 of the 13 OPEC countries, Griffin rejects all but the cartel model. The clear-cut nature of his result points to the superiority of the partial marketsharing-cartel model for all 11 OPEC members for explaining OPEC behavior. For the non-OPEC countries, on the other hand, the competitive model could not be rejected for 10 of the 11 non-OPEC producers. Griffin's conclusion carved out a picture of a market-sharing cartel with some competitive suppliers. Indeed, results from the majority of studies are in agreement about treating OPEC as a cartel-related organisation. For instance, the result by Alhajji and Huettner (2000) indicates that OPEC behavior is more in line with a dominant-firm model (with the dominating entity being Saudi Arabia). This is a variant of the cartel model. Standard microeconomic theory predicts that demand price elasticity (absolute value) increases its value as the price increases. That is, a monopolist or cartel does not operate in the inelastic range of a demand curve. While the theory holds true for most commodities, the price elasticity for oil, estimated thus far, has not exceeded. For example, a survey made by Greene (1991) indicated that, at the time, all short-run estimates were below 0.176 (at US$50 per barrel according to the US Energy Information Administration), as were all long-run estimates after taking the adjustment coefficient into consideration. By the 1990s, however, the emphasis had shifted to the strategic behavior of OPEC under a dynamic setting or oligopolistic competition (Wirl, 2008, 1029). In reality, however, random shocks persist, especially in the world oil market, where political, financial and economic forces constantly intertwine in such a way that the accumulated impacts are stochastic in nature. Wirl (2008) illustrates the possibility of discontinuous jumps in oil prices as a result of using the initial low price to "entrap" consumers and to discourage fringe supplies before raising the price substantially. Such a strategy is profitable due to extremely low short-run price elasticity values and may be preferred to the Hotelling method (Wirl, 2008, 1039). Similarly, Suranovic (2003) simulates a nonlinear optimisation model with OPEC acting as a close-knit cartel to maximise the present discount value of future revenues. In both scenarios, this model produces quite a few price shocks, which implies inelastic demand when quantities remain relatively stable. Other explanations, such as political motives and mean reversion, are generally not thought to be major factors in producing price jumps (Wirl, 2008). In an interesting fuzzy cartelisation model, Wirl (2008) shows that the S-shaped supply curve, bounded by monopoly price and competitive price (marginal cost) with an equilibrium demand function, is capable of producing different cycles. OPEC's behavior can be characterised by calibrating the weights assigned to monopoly price and marginal cost, with the segment of backward-bending supply curve being off-limits. When the price is above the long-run demand, as was the case in July 2008, the price is expected to fall on to the end point of the backward-bending supply curve segment before plummeting rapidly to its beginning point, where cycles start. Such a model offers an insightful and timely explanation of OPEC's behavior with recurrent cycles or sudden jumps. With demand uncertainty, it is little wonder that price shocks cluster in abundance. It is apparent that the stable price is established through the equilibrium of total world demand and total supply including OPEC and non-OPEC production. Since the replacement from oil to other products is complex in the short run, the price change is largely created by the immediate increase or decrease in oil production from OPEC members. OPEC can use its monopoly power to maximise its revenue by adopting a policy of periodic price shocks to keep demand inelastic, so that importing countries do not react to price changes by implementing policies that would reduce dependence on the foreign oil supply (Suranovic, 2003, 71). Elasticity of demand depends not only on the availability of substitutes but also on market competitiveness. OPEC emerged as an effective cartel in 1971. The Arab-Israeli War of 1973, a subsequent oil embargo and the nationalisation of oil production in member countries enabled the cartel to raise the price of OPEC oil from US$2 per barrel in 1971 to US$34 in 1981. The market changed from a competitive one, to one in which OPEC was able to exercise a considerable degree of monopoly power. Demand, in turn, changed from a relatively elastic individual market demand curve, to a relatively inelastic industry cartel demand curve. OPEC countries were able to raise the oil price even further under this structural change in demand. More specifically, this was the direct result of unstable relation. Speculative activity can also affect the volatility in oil prices. Some speculative activities can drive prices upward in a bubble or downward in a crash just like the unstable case analysed above. Economic recession, political disturbance or wars can enhance this kind of speculation. It is evident from the historical real crude oil price that there was not much volatility in the oil price until 1973. The oil price spiked after the Yom Kippur War between Israel and the Arab nations. The oil embargo of 1973 marked the first energy crisis. The second energy crisis began in 1979 during the Iranian revolution and the subsequent Iran-Iraq War from 1980 to 1988. The price elasticity of demand depends not only on the availability of substitutes but also on market competitiveness. In the 1950s and 1960s there were numerous independent producers in the industry, and the demand facing the individual producer was relatively elastic even though industry demand was rather inelastic. The regime shift occurred slightly after OPEC emerged as an effective cartel in 1971 after the Tehran Agreement. The ensuing Arab-Israeli War of 1973 , the subsequent oil embargo and the nationalisation of oil production in member countries enabled the cartel to raise the price of crude oil from US$2 per barrel in 1971 to US$34 in 1981. Another factor affecting the structural change in 1973 was that the Texas Railroad Commission set proration at 100% for the first time in 1971. The power to control crude oil prices shifted from the US to OPEC. The market changed from a competitive one, to one in which OPEC was able to exercise a considerable degree of monopoly power. Demand, in turn, changed from a relatively elastic individual market demand curve to a relatively inelastic industry cartel demand curve. The OPEC countries could therefore raise the oil price even further under this structural change in demand. This could have been a direct result of a structural break in the world oil market from a pre-embargo competitive oil market to a post-embargo cartel market. Another structural change occurred during the Iranian revolution and the Iran-Iraq War from 1978 to 1988. As a consequence, the combined production of both countries was only one million barrels per day in 1980, which was 6.5 million fewer barrels per day than was the production in the previous year. The oil prices spiked from US$ 14 in 1978 to US$35 in 1981. Higher prices made other products more substitutable and the demand became more elastic. Consumers used better home insulation, employed more energy-efficient production processes and drove more fuel-efficient automobiles. The higher prices also gave rise to increased exploration and production outside of OPEC. Non-OPEC production increased by 10 million barrels/day from 1980 to 1986. During this period, OPEC failed to stabilise prices because of its inability to set sufficiently low quotas. Such measures and events made the demand relatively more elastic. These factors, along with a global recession, caused a reduction in demand that led to falling crude oil prices. Lower oil prices combined with more elastic demand (relation (B)) caused the price to go even lower. This unstable relation (B) reinforces the intensity of volatility in the oil price. The oil price was below US$10 per barrel by mid 1986. The volatility of crude oil prices was caused not only by supply interruptions, such as war between Iran and Iraq and global recession, but also by structural changes in demand. The majority of the past 18 years has been economically prosperous. As a result, higher GDPs have increased the demand for crude oil, especially from China and India. In addition, an astronomical sum of "hot money" that escaped from housing and stock market bubbles has also increased demand for futures contracts on oil, which will in turn increase current demand in the face of significant speculation. The right shift of the demand curve, whose upper part is increasingly steep, may well leave the price on the steep segment of the curve. As a result, high oil prices are realised on the portion of the demand curve with intense convexity via an increase in either GDP or speculation. Geometrically, a point elasticity is the ratio of tangent measurement between the origin and a point on the demand curve and slope on the point. Low oil prices during the 1998-99 period suggest that it is still possible to have US$ 10 per barrel, especially when some members do not stick to the agreed quota: this is a special case, in which competitive price dominates monopoly price. A recession as serious as the one we are currently experiencing could increase the price elasticity or move it closer to trajectory . In order to get independence, oil-consuming countries need to support policies that promote alternative fuel use, maintenance and greater fabrication of domestic oil. 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