Oil Price Drivers and Movements: The Challenge for Future Research
28 Pages Posted: 29 Apr 2013 Last revised: 16 Apr 2014
Date Written: July 1, 2012
The complexity of the world oil market has increased dramatically in recent years and new approaches are needed to understand, model, and forecast oil prices today. In addition to the commencement of the financialization era in oil markets, there have been structural changes in the global oil market. Financial instruments are communicating information about future conditions much more rapidly than in the past. Prices from long and short duration contracts have started moving more together. Sudden supply and demand adjustments, such as the financial crisis of 2008-2009, faster Chinese economic growth, the Libyan uprising, the Iranian Nuclear standstill or the Deepwater Horizon oil spill, change expectations and current prices. Although volatility appears greater, financialization makes price discovery more robust. Most empirical economic studies suggest that fundamental values shaped expectations over 2004-2008, although financial bubbles may have emerged just prior to and during the summer of 2008.
With increased price volatility, major exporters are considering ways and means to achieve more price stability to improve long-term production and consumption decisions. Managing excess capacity has historically been an important method for keeping world crude oil prices stable during periods of sharp demand or supply shifts. Building and maintaining excess capacity in current markets allow greater price stability when Asian economic growth suddenly accelerates or during periods of supply uncertainty in major producing regions. OPEC can contribute to price stability more easily when members agree on the best use of oil production capacity.
Important structural changes have emerged in the global oil market after major price increases. Partially motivated by government policies major improvements in energy and oil efficiencies occurred after the oil price increases of the early and the late 70s such as the improved vehicle fuel efficiency, building codes, power grids and systems etc. On the supply side, seismic imaging and horizontal drilling as well as favorable tax regimes expanded production capacity in countries outside OPEC. After the oil price increases of 2004-2008, investments in oil sands, deep water, biofuels and other non-conventional sources accelerated. Recent improvements in shale gas production could well be transferred to oil-producing activities, resulting in expanded oil supplies in areas recently considered prohibitively expensive. The search for alternative transportation fuels continues with expanded research into compressed natural gas, biofuels, diesel made from natural gas, and electric vehicles.
Still some aspects of the world oil market are not well understood. Despite numerous attempts to model the behavior of OPEC or its members, there exists no credible, verifiable theory about the behavior of the 50 years old organization. OPEC has not consistently acted like a monolithic cartel, constraining supplies to raise prices. Empirical evidence suggests that members sometimes coordinate supply responses and at other times compete with each other. Supply-restraint strategies include slower capacity expansions as well as curtailed production from existing capacity. Regional political considerations and broader economic goals (beyond oil) are influential factors in a country’s oil decisions. Furthermore, the economies of OPEC members as well as their financial needs have changed dramatically from 1970s and 1980s.
This review represents a broad review of economic research and literature related to the structure and functioning of the world oil market. The theories and models of oil demand and supply reviewed here, although imperfect in many respects, offer a clear and well-defined perspective on the forces that are shaping the markets for crude oil and refined products. Much work remains to be done if we are to achieve a more complete understanding of these forces and the trends that lie ahead. The contents that follow represent an assessment of how far we have come and where we are headed. Of course, the entire world shares a vital interest in the many benefits that flow from an efficient, well-functioning oil market. It is intended and hoped, therefore, that the discussion in this review will find a broader audience.
Keywords: oil prices, supply and demand analysis, financial markets
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