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The Oil Market: Speculating on Global Change


The war in Ukraine has sparked chaos in the energy market. Oil prices soared from $90 to over $120 per barrel, and consumers are experiencing serious pain worldwide, as oil is vital for modern civilization. As a result, Western countries are now working on new partnerships to become independent from Putin’s oil, with the crisis exacerbating the need for new and clean sources of energy. On Tuesday 16th, August 2022, the price of crude oil plummeted under $89 for WTI and $94 for Brent. The slumping price of oil during this month was due to the perspective of slowing demand and a re-establishment of the Iran Nuclear Agreement. But what is behind the mystic pattern of oil prices? Who is the real architect of today’s oil market?

I felt particularly concerned regarding this sentence by George Clemenceau over the summer: “Oil is as necessary as blood.” Oil, also known as black gold, has a tremendous impact on every aspect of our lives. The high price of oil is a contributor to the high increase in inflation. Thankfully, this sharp rise in inflation became less severe in July 2022 in the USA and Canada, when oil prices finally began to cool somewhat, and the US CPI dropped from 9.1% in June to 8.5% in July. These receding oil prices are a blessing for consumer spending. As a principle, when oil prices go down by 10%, the growth of the economy sees an increase ranging from 0.1 to 0.5 percentage points.

In this new era of climate awareness, humanity is seeking out alternative sources of energy. Blackrock and NextEra Energy invested 300 million dollars in green hydrogen company Monolith this year. Meanwhile, Neste envisions making our travel greener by producing 1.9 billion liters of SAF per year by 2023. On the other hand, oil companies are now facing tremendous pressure from governments, environmentalists, and investors to address climate change. Nowadays, investors are more concerned about climate issues, forcing oil companies to make radical changes for the survival of our planet. According to an annual survey released by Boston Consulting Group on January 6th, 2022 concerning 250 major institutional investors, more than four in five people believe that these companies should prioritize long-term emissions reductions. Therefore, oil companies are making sacrifices in order to make their businesses greener. In December 2021, Shell sold 9.5 billion dollars of shale fields in America’s rich Permian Basin.

Nonetheless, we will continue to be dependent on oil for the foreseeable future. Oil investors are addicted to the product’s high return, and it will be very difficult to prevent such an appetite. According to Markit, since 2010, oil and gas businesses have generated a median annual operating return on capital of 8.3% – this in comparison to 5% for renewable energy. Moreover, oil is still a pillar of our civilization. For Vaclav Smith, eliminating oil will mean a loss to the global economy of more than 5 trillion dollars.

The story of oil prices is a confrontation between those who believe in the free market and those who think that an unregulated market is a disaster for the oil industry. Since the beginning of the oil industry, some have postulated that without any regulation of supply, oversupply will lead to price crashes and the collapse of numerous companies. Standard Oil was the first to perfectly stabilize oil prices, achieving a price volatility of 24.9% between 1880-1911. TRC and Seven Sisters achieved the best performance in history with a price variation of 3.6% between 1932-1972. This company was characterized by its strong cooperation between the government and the private sector, along with a fierce willingness to be disciplined.

The last entity that exerted control in the oil market was OPEC, which gradually gained power by increasing administration prices. The Teheran Agreement and Tripoli Agreement in 1971 increased administration prices and the percentage of producer countries’ participation in profit sharing. In 1973, OPEC weaponized the oil market by establishing an embargo. Unlike its predecessors, the lack of cohesiveness didn’t enable the company to control and stabilize its prices. The price change was 24.1% during OPEC’s era. However, OPEC lost its grip on power and was hit by diminishing demand and an explosion of production from non-OPEC countries, mostly due to the discovery of the North Sea oilfield Brent on November 11th, 1976. The cheating behavior among its members amplified the erosion of OPEC’s domination. In October 1985, Minister Yamani said that “Saudi Arabia would no longer play the swing producer role.” On April 21st, 2016, Prince Mohamed bin Salman confirmed the determination to follow the free market rule: “We don’t care about oil prices – $30 or $70, they are all the same to us.”

Since 2008, the free market has dictated the price of oil after 70 uninterrupted years of price control or cartelization. The return of high price variation is back in town with a volatility of 38.4%. 2008 was an illustrative year, as the price of crude oil crashed from $144 to $37 per barrel between August and November, then jumped back to $70-80 per barrel. In this third era of the free oil market, financial markets have cemented their power. In July 1988, the IPE created a Brent future contract. In December 1988, OPEC accepted the Brent future contract as a benchmark of oil prices. These events marked the death of OPEC and the victory of the financial market.

In today’s market, the price of crude oil is mostly determined by speculative finance rather than the equilibrium between supply and demand in the physical market. The magnitude of trading on the derivatives market has overcome the dynamic of the real market. From January 2008 to December 2010, 7,600 billion dollars were exchanged in the physical market in comparison to the 51,000 billion in the derivatives market. This new normal has attracted financial institutions that aim to take advantage of this market configuration but also reshape the behavior of oil companies. Oil companies are following in the footsteps of financial institutions and setting up large trading activities. In a normal year, BP realizes more than 2 or 3 billion dollars in pre-tax profit, and Shell more than 5 billion dollars from its trading activities.

The war in Ukraine has been a turning point. In researching their energy freedom, Western countries are more likely to diversify their partnerships while also emphasizing their transition toward a greener economy. The hidden benefit of this war could be the acceleration of this change, which is highly expected by many environmentalists. According to the simulation made by The Economist in an article titled “Why Energy is Here to Stay,” spending on ten natural resources will drop from 5.8% of the GDP to 3.4% by 2040. In the meantime, spending on green metals will soar by over 1 trillion dollars by 2040. From this perspective, could we reasonably expect a fall in oil prices in the long-term future?

Sources:

Newspapers:

Bloomberg: Big Oil’s Secret World of Trading

CNBC: The Other Reason Why Food Prices Are Rising

The Economist: Ways to Make Aviation Fuel Green

The Economist: The Coming Food Catastrophe

Books:

Crude Volatility

Understanding Oil Prices

A Trader’s First Book on Commodities

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