The world oil market
All petroleum crude (oil) purchased or sold in the world is traded in three basic ways Spot Trading, Futures Market, and Contract arrangement. Spot transactions are on-the-spot agreements to buy or sell a single shipment at an agreed price. Since suppliers and buyers use these to bridge short-term gaps between supply and demand, spot market prices are good indicators of the supply and demand situation, rising prices indicating shortage and vice versa.
There are spot markets for different products namely crude oil, heating oil, gasoline and so on, and for different regions such as Rotterdam, US Gulf, Singapore etc. Futures markets cover trades that are promises to sell and buy a consignment of oil of a specified quality, delivered at a specified place at an agreed upon price up to 18 months in the future. Very little, if any, oil changes hands physically in futures markets, these however, provide current prices and expected future trends and are more in the nature of financial transactions rather than physical trade in oil.
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Usually the spot and futures prices benchmark the contract price, to explain, the delivered price of the oil depends upon the spot market at the agreed time of delivery plus or minus an agreed amount depending upon the other conditions of the contract, such as credit terms, quantity and quality. Quality adjustments are based on the standard oil being traded namely West Texas Intermediate crude oil or North Sea’s Brent Blend for the US and European markets respectively. Dubai is the benchmark for transactions in Singapore and the East.
In the US, some sale of the domestic production of oil is at a ‘Posted Price’, a different method of pricing of the indigenous product (Transactions). Futures prices of crude are $ 69. 59 per barrel for May 2006 delivery and $ 70. 22 per barrel, for June delivery. These are the closing prices of May 8th trading on the NYMEX for Brent crude (Trading Quotes). 2. Some oil producing nations have formed a cartel to control the production, shipments and prices of crude. This organisation called the Organisation of Petroleum Exporting Countries (OPEC).
Appendix-1 shows the countries that form part of OPEC and their average production over the past three years (2003-05). Appendix-2 provides details of countries that produce significant quantities of crude but who are no a part of the OPEC and their average production over the past three years (2003-05). Appendix 3 gives details of the major Exporters, Consumers and Importers of Oil (International Petroleum Monthly). Saudi Arabia, Russia, Iran and North Sea operations are the major producers of oil. The US is the largest consumer and importer of oil followed by China and Japan.
The world oil market is a Homogenous Co-operative Oligopoly. A broad definition of an oligopoly is a monopoly of many. “The distinguishing characteristic of an oligopoly is that there are a few mutually interdependent firms that produce either identical products (homogeneous oligopoly) or heterogeneous products (differentiated oligopoly)” (Bookrags). Oil has no substitute. The consumer, whether large or small, has no alternative for the product, has no way of increasing total utility and with the supply and prices being controlled by a handful of suppliers has absolutely no way of influencing prices.
This is a classic case of a monopolistic market. As is evident from the figure presented in Appendix 3, the largest exporters in the world, other than Russia, Norway, Mexico, Kazakhstan, and Qatar, are a part of the OPEC. The OPEC decides upon the levels of production and exports all with a view to control prices by maintaining a scarcity in the market. The other countries can do little but toe OPEC’s line. The non-availability of natural resources restricts entry of new players into the market.
Since the product of all the players is essentially the same – crude petroleum oil, with only small variations in quality, the term Homogenous Oligopoly applies perfectly to this market. At present oil is trading at all time highs of over 70 US dollars to the barrel though nothing has changed in the market since the time it was trading 10 dollars lower. In fact, the pressure of winter heating oil has reduced and prices should have come down, But the OPEC countries decided to reduce production quotas of member countries and created an artificial scarcity giving an upward push to the prices.
Information about the oil market is transparent and openly available. Religious and cultural ties bind most members of the OPEC and therefore, the cartel is very successful in implementing its strategies for maximisation of profit. 4. Supply and demand usually determine the equilibrium position in any market, that is, a point where the total demand is being met by the total supply. The market is stable, the producers as well as the customers are satisfied, and prices are steady. Any disturbance in these conditions will lead to instability and markets will have to adjust to reach a new equilibrium point.
The three scenarios in the oil market may be analysed as under: a. The Venezuelan Government persuades the OPEC to cut production quotas. Supply will reduce, but no change shall take place in the demand. The bold lines represent the demand and supply curves before the change. At equilibrium, a quantity Q1 sold at price P1. The decrease in supply, represented by the dotted supply line, is not matched by any decrease in demand. Therefore, the market will tend to find a new equilibrium represented by price P2 and quantity Q1 remaining same.
In practical terms the demand may come down slightly as nations tighten their belts and the new price may be a little lower than P2 but not significantly so. b. The USA decides to build up its oil reserves. This scenario represents an increase in the demand for oil, not matched by any change in the supply position. Here the situation would be as represented by the following diagram. The existing equilibrium point is represented by the quantity Q1 being purchased at the price P1. The new demand curve shifts to the right (dotted line).
To meet the new demand the supply needs stepping up – but this shall happen only if price increase, to P2, matches the increase in supply. c. The high price of oil induces new investment in oil production. This situation will lead to an increase in supply but the demand for oil does not go up. Practically, demand will go up a little in view of better supplies and consequent lower prices, but the increase will not be significant to affect markets. The following diagram explains the revised situation. With the demand, remaining at Q1 the increased supply will bring down prices to P2 the new equilibrium point.
5. Demand or supply elasticity is the extent to which demand or supply changes with a change in the price (Elasticity). Supply of oil will be inelastic in the short term. We can understand this if we examine the major factors underlying the supply situation of oil in the world. Oil occurs naturally and is not a manufactured product. There is no discovery of significant and commercially exploitable new oil deposits; thus, the supply is likely to remain constant. The factors that influence change in demand due to change in price are: * Availability of substitutes, * Change in income levels, and * Time.
None of these has any effect on the supply of oil. Substitutes for oil are a long way away and whatever the income levels of people the demand for oil will not change much in the short term since the availability (supply) is limited. The supply can become elastic only under special circumstances. New wells are found, the OPEC breaks up or there is a drastic change in usage patterns with the evolution of path-breaking new technology that leads to higher efficiencies in the usage of petroleum products or substituting them totally. 6. Scarcity is a large shortfall in supply as compared with demand.
There is a limit to all resources whether they are workpeople, machines, capital assets, area of land, reserves of oil and minerals. Economics is all about the making of choices between what needs to be produced using the limited resources we have and what should not. If something is scarce then it will have a larger value in the market (tutor2u. net). With the evolution of society and increase in population, there is an increased demand for goods and services, to be met using the limited resources that are available. a. Oil itself is a natural resource and there is a limit to how much is available and how much can be produced.
As demand grows and production remains constant, and maybe even declines in the future, conditions of scarcity arise and prices keep going higher. Scarcity of oil is bound to have deep implications for society. We need to meet the needs for energy to heat our homes, power our transport, and provide fuel for other vital production activities. With oil prices rising and scarce conditions obtaining in the market, society shall have to make a choice as to what it can forego in favour of what (ingrimayne. com) b. There is a large reservoir of oil available, of which we draw only a small bit every year.
A lot of research activity today focuses on finding alternatives to fossil fuels, and with some success. With increasing safety in operations of nuclear power generation, we can foresee that a large proportion of the power generation in the future shall be from this source, easing the pressure on oil. Progress on other alternative, renewable, source of energy is also good. Rising prices will also make many of the existing reserves, but not considered financially viable at present, become viable and these will come into production. Therefore, with judicious use and conservation, there is really no scare of the world running out oil.