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NAME Naman Jain

INSTITUTE IIM Lucknow


BATCH 2017-19

Crude Oil price dynamics


The rise and the fall of OPEC ?
The effect of oil prices on economies around the world is understated. For a nation which is the
3rd highest importer of crude oil, BJP has somewhat enjoyed a reign of low crude prices. No
wonder the government has been able to reduce the fiscal deficit to a mere 3.5 % of the GDP,
which stood at 7.8 % in 09. But what explains this high degree of volatility?

Image source : http://www.macrotrends.net/1369/crude-oil-price-history-chart

Oil, just like any other commodity, is governed by the laws of demand and supply. Much like the
rest of the business world. The demand can be thought of as a function of economic growth
especially that of the emerging markets since that is where there is a lot of scope for the same.
The surge in prices prior to 08 was primarily due to rapidly expanding oil demand in Asia, as
Chinas industrialization kicked into a higher gear. The subsequent plunge, of course, is very
well explained by the subprime crisis that had far-reaching consequences globally. While this
seems to be obvious right now, it is increasingly tricky to actually predict such events.
The same holds true from the supply side too, perhaps, to a lesser extent. An oversupply is likely
to exert a downward pressure on prices, precisely what the world is experiencing now. Which
brings us to the crux of this discussion relevance of OPEC and impact of US shale. OPEC or
Organization of the Petroleum Exporting Countries has had an almost unbreakable grip on the
global crude-oil market ever since it was formed in 1960. With three-quarters of the worlds
proven oil reserves under their hold, it is often cited as a classic example of a cartel
competitors cooperating to control prices and reduce market competition. Until early 70s, prices
were predominantly guided by the demand side, i.e. the oil importing nations. However, the
balance of power soon shifted when OPEC nations realized their power through the unintended
consequence of war prices increased by tenfold in less than a decade. Also, OPEC set and
revised production targets for its member nations and had been able to control prices to a fair
extent. However, the dynamics of crude market has rapidly changed with the entry of US shale
oil.
The story of shale oil is a rather fascinating one. Shale oil isnt a recent discovery the US
always had enormous deposits lying underneath. But the record prices attained a decade ago
meant that these reserves were suddenly economical to explore. At a time when most industry
experts thought it was not possible to extract this oil, a small company tinkered with fracking and
horizontal drilling techniques leading to the US shale boom. As supply soared and prices fell,
shale companies kept fiddling and managed to cut costs and pump oil more efficiently than
anyone thought possible. The result? Prices fell from over $100/bbl in 2014 to under $30/bbl two
years later. This was aided by OPEC members consistently exceeding their production ceiling
during that period, resulting in a supply glut, and a slowdown in economic growth in China and
Europe, resulting in lower demand. Again, easy to comprehend in hindsight, difficult to forecast.
In response to the record low prices so low that even for some of OPEC nations, it became
uneconomical to produce oil, production cuts were prescribed by the de-facto head of OPEC,
Saudi Arabia. The move, backed by Russia, could mean an output cut by as much as 1.8 million
bbl/d (>2 % of global production). A higher than expected compliance rate by members,
augmented by rising global demand and big shortfalls in offshore production led many experts to
believe that the market would very soon face a shortage of supply and prices would rise again.
In my opinion, that is where OPEC lost the game. With a man like Trump in office with his pro-
fossil fuel policies, OPEC merely gifted a portion of its market share to the US. The aggressive
drilling that Trumps election has ensued bears testimony to the fact that crude is now facing
strong resistance at the $50 level. The US, which is one of the largest producers of oil, is also the
largest importer of oil. Trump is not only reducing their reliance on oil imports, but also creating
jobs for many of the unemployed southerners - exactly what his agenda stated prior to his
election. For a person who believes global warming is a concept created by the Chinese,
concern about the environment is probably not very high on his priority list.
With prices not reaching expected levels, OPEC countries like Libya and Nigeria have gradually
increased output levels. The cases of Iraq and Iran, one plagued by war and the other impacted
by (recently lifted) economic sanctions, does not help the case. The consequent lower
compliance among members an inherent flaw with any cartel can only mean lower prices.
Overall, the outlook for crude oil is bearish.
However, this does not mean that OPEC will no longer be relevant. While the supply of oil is
unlikely to lower, there is immense scope for growth in demand in the developing world. We still
have a huge percentage of the population still in poverty using a fraction of the oil the developed
world uses. The demand for plastics and other petrochemicals will grow. Fuel for trucks, ships,
planes all will grow. Gasoline demand will certainly grow for some time to come even if EVs
become competitive. We must realize that many places still dont have a reliable power grid.
Beyond that we have population growth which will be adding several hundred million new
humans in the next few years they will consume plenty of resources. Even in the developed
world, it will take some time for EVs to be cost competitive with internal combustion cars and
even more time for consumers to really take to them.
We spoke about demand and supply of oil being the principal guiding factors affect the price
levels. However, it is important to note that just like in capital markets, it is actually the
expectation of the investors in oil futures that impact price movements. Finally, in words of the
IEA, Attempting to understand how the oil market will look during the next five years is today a
task of enormous complexity. Some certainties that have guided our past outlooks are now not so
certain at all.

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