In the World Gas
Conference held on the 7th of June, Chief Operating Officer and
Executive vice-president of Patronas: a Malaysian government owned corporation,
Datuk Wan Zulkiflee Wan Ariffin, predicted that oil prices would be declining.
As oil is one of the major sources of energy and a commodity that many
industries such as manufacturing, transportation, energy and pharmaceuticals,
are reliant up on, the fluctuations in oil prices would have important
ramifications on these industries. Thus, it is important to see why the prices
are expected to decline and the effect of this on those depending on oil.
Just like other markets, the global price of oil is also determined by the price mechanism, the interaction of demand and supply. Hence to forecast the changes in oil prices, we need to look into the factors that affect the demand and supply for oil and look into the price elasticity of the demand and supply of oil.
As Mr. Datuk Wan Zulkiflee Wan Ariffin mentioned, economic uncertainty would have an impact on the price of oil as there is a strong correlation between the demand for oil and the rate of global economic growth because oil is an essential input for many industries. In the second half of 2008, when the global economy entered recession, oil prices fell from $147 a barrel to $40 barrel. When there is a slowdown in the economy, where all economic activity is low, industries reliant on oil would reduce their output due to less demand for their goods, and this in turn reduces the demand for oil since it is derived demand. Currently, the world economy is a train wreck with the Eurozone dictated by heavy debts, growing unemployment, low GDP; America with an unemployment rate of 8.2% and low GDP growth forecast; even the emerging markets such as the BRIC nations are expected to have low economic growth. These factors would no doubt affect the demand for oil adversely,
Apart from economic uncertainty, there are other factors which affect the demand for oil, which Mr. Datuk Wan Zulkiflee Wan Ariffin did not mention. One such factor is the relative price of substitutes for oil. Substitutes are those goods that can be used in place of another good. Substitutes for oil, is limited but there are few sources, which could be used as an alternative of oil. These include renewable sources such as: ethanol, wind energy and solar energy, tar sand and natural gases. But their scope as an alternative for crude oil is limited. According to an article in Forbes magazine ‘ethanol is dependent on huge quantities of sugar cane or corn’, and ‘tar sand takes 1000 cubic feet of natural gas and it requires lot of water to produce a barrel of what equates to sour crude which is also difficult to refine’. He also states that ‘although wind and solar energy has its place, it is insignificant and cannot be used as raw materials for pharmaceuticals and plastics’. But research and development is being carried out to find a successful alternative for oil, and if they succeed, we would see oil prices fall as demand for oil decreases.
One of the most important factors that affect the demand for oil is speculation and hedging; purchasers buying with the hopes of selling them at higher price. In the oil market, ‘traditionally hedging refers to those with a commercial interest and exposure to physical commodity’ whereas speculation refers to those trading futures contracts-agreements among two party to sell a given commodity at an agreed upon date in the future. Speculators look into the demand and supply side factors affecting oil prices, and based on this they would be trading. If they think the world economy is slowing down and oil prices are going down, they may sell their oil shares now to gain higher profits. Or if they think those oil prices are going to rise they may buy more now hoping to gain higher returns in the future.
Supply side factors such as external shocks; closure of oil rigs and terrorist attacks, influence the price of oil as it decreases the quantity of oil available. The Yom Kippur War of 1973 saw Egypt, Syria and their neighboring countries placing an embargo on the supply of oil to US and other western counties, because US backed Israel. This lead to a huge decrease in the supply of oil and oil prices skyrocketed. Currently, there are fears that the Iranian nuclear development program would accelerate oil prices. This is because, Iran: the 3rd biggest oil producer in OPEC, has sanctions imposed on them by the United States and European Union which include bans on Iranian oil imports. Also, there’s threats of an Israeli attack, and ‘Iran’s threats of closure of the vital artery of the Stait of Homuz’ which could turn into a much wider war than just a broader conflict with Iran. These factors could mean repetition of history, with oil prices escalating due to low oil supplies as in the 1973 Yom Kippur war. Also growing skepticism of oil supplies could mean countries stockpile oil now, which decreases the current supply of oil and increases the price. This contradicts Mr. Datuk Wan Zulkiflee Wan Ariffin’s prediction that oil prices would fall.
But the extent to which the aforementioned points affect the oil prices depends on the price elasticity of demand and supply, which is about how the demand and supply respond to changes in the prices of oil. As mentioned above, oil has relatively few substitutes that could be used, this implies, that even though the price of oil changes, the demand for oil is likely to changes less than proportionate to the change in price making the demand for oil rather price inelastic. On the other hand supply of oil also remains price inelastic because in the short run, supply depends on proven oilrigs and reserves. The price inelasticity of demand coupled with price inelasticity of supply explains why the oil prices are so volatile. The diagram1 shows, demand and supply which is price inelastic, and a shift of the demand curve to the left (decrease in demand) due to declining economic growth, and a shift of the supply curve to the left (decrease in supply). According to the diagram, the price increases but the increase in price is not that significant, but we need to consider that the actual change in price will be determined by how much the demand and supply changes and the level of price inelasticity of demand and supply.
Just like other markets, the global price of oil is also determined by the price mechanism, the interaction of demand and supply. Hence to forecast the changes in oil prices, we need to look into the factors that affect the demand and supply for oil and look into the price elasticity of the demand and supply of oil.
As Mr. Datuk Wan Zulkiflee Wan Ariffin mentioned, economic uncertainty would have an impact on the price of oil as there is a strong correlation between the demand for oil and the rate of global economic growth because oil is an essential input for many industries. In the second half of 2008, when the global economy entered recession, oil prices fell from $147 a barrel to $40 barrel. When there is a slowdown in the economy, where all economic activity is low, industries reliant on oil would reduce their output due to less demand for their goods, and this in turn reduces the demand for oil since it is derived demand. Currently, the world economy is a train wreck with the Eurozone dictated by heavy debts, growing unemployment, low GDP; America with an unemployment rate of 8.2% and low GDP growth forecast; even the emerging markets such as the BRIC nations are expected to have low economic growth. These factors would no doubt affect the demand for oil adversely,
Apart from economic uncertainty, there are other factors which affect the demand for oil, which Mr. Datuk Wan Zulkiflee Wan Ariffin did not mention. One such factor is the relative price of substitutes for oil. Substitutes are those goods that can be used in place of another good. Substitutes for oil, is limited but there are few sources, which could be used as an alternative of oil. These include renewable sources such as: ethanol, wind energy and solar energy, tar sand and natural gases. But their scope as an alternative for crude oil is limited. According to an article in Forbes magazine ‘ethanol is dependent on huge quantities of sugar cane or corn’, and ‘tar sand takes 1000 cubic feet of natural gas and it requires lot of water to produce a barrel of what equates to sour crude which is also difficult to refine’. He also states that ‘although wind and solar energy has its place, it is insignificant and cannot be used as raw materials for pharmaceuticals and plastics’. But research and development is being carried out to find a successful alternative for oil, and if they succeed, we would see oil prices fall as demand for oil decreases.
One of the most important factors that affect the demand for oil is speculation and hedging; purchasers buying with the hopes of selling them at higher price. In the oil market, ‘traditionally hedging refers to those with a commercial interest and exposure to physical commodity’ whereas speculation refers to those trading futures contracts-agreements among two party to sell a given commodity at an agreed upon date in the future. Speculators look into the demand and supply side factors affecting oil prices, and based on this they would be trading. If they think the world economy is slowing down and oil prices are going down, they may sell their oil shares now to gain higher profits. Or if they think those oil prices are going to rise they may buy more now hoping to gain higher returns in the future.
Supply side factors such as external shocks; closure of oil rigs and terrorist attacks, influence the price of oil as it decreases the quantity of oil available. The Yom Kippur War of 1973 saw Egypt, Syria and their neighboring countries placing an embargo on the supply of oil to US and other western counties, because US backed Israel. This lead to a huge decrease in the supply of oil and oil prices skyrocketed. Currently, there are fears that the Iranian nuclear development program would accelerate oil prices. This is because, Iran: the 3rd biggest oil producer in OPEC, has sanctions imposed on them by the United States and European Union which include bans on Iranian oil imports. Also, there’s threats of an Israeli attack, and ‘Iran’s threats of closure of the vital artery of the Stait of Homuz’ which could turn into a much wider war than just a broader conflict with Iran. These factors could mean repetition of history, with oil prices escalating due to low oil supplies as in the 1973 Yom Kippur war. Also growing skepticism of oil supplies could mean countries stockpile oil now, which decreases the current supply of oil and increases the price. This contradicts Mr. Datuk Wan Zulkiflee Wan Ariffin’s prediction that oil prices would fall.
But the extent to which the aforementioned points affect the oil prices depends on the price elasticity of demand and supply, which is about how the demand and supply respond to changes in the prices of oil. As mentioned above, oil has relatively few substitutes that could be used, this implies, that even though the price of oil changes, the demand for oil is likely to changes less than proportionate to the change in price making the demand for oil rather price inelastic. On the other hand supply of oil also remains price inelastic because in the short run, supply depends on proven oilrigs and reserves. The price inelasticity of demand coupled with price inelasticity of supply explains why the oil prices are so volatile. The diagram1 shows, demand and supply which is price inelastic, and a shift of the demand curve to the left (decrease in demand) due to declining economic growth, and a shift of the supply curve to the left (decrease in supply). According to the diagram, the price increases but the increase in price is not that significant, but we need to consider that the actual change in price will be determined by how much the demand and supply changes and the level of price inelasticity of demand and supply.
There are other forces too, which
influence oil prices. Governments may intervene to stabilize the price
volatility and may impose price caps to ensure that the oil prices remain more
or less the same. Also OPEC- the organization of petrol exporting countries may
intervene as it has in the past. Thus, Mr. Datuk Wan Zulkiflee Wan Ariffin, statements is
true to some extent, but since there are other factors that influence the
price, these should all be considered before we see the final impact on oil
prices.
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