The Logic in Oil Price Evolution

The oil market is a global commodity market. It is thus influenced by a variety of factors. The graph below models the various factors that can influence oil price variations.

One of these elements is, of course, demand. Demand is affected by a multiplicity of factors, both short-term and mid-term. Demand is first a result of short-term economic activity, which drives more or less transportation or industrial needs. Weather and seasons can also be an important factor—oil is used for heating (oil represents 20% of district heating energy consumption). Mid-term demand patterns are more related to the economic stability and development of nations. The transportation sector accounts for 54% of all oil demand and is thus critical in predicting oil consumption evolutions. Industrial development comes second, accounting for over 31% of total oil consumption.

Another element which influences the price at which oil is purchased from producing countries is the level of oil inventories. They generally range around 50 days of consumption but have evolved in the recent years. A structural increase in inventories pushes prices down while relatively low inventories tend to pull prices up.

Also, oil production varies significantly due to a variety of factors. Production disruptions are frequent, sometimes due to geopolitical tensions. Wars in the Persian Gulf in the 1980s and 1990s, in Iraq in 2003, and in Libya in 2011 have disrupted global oil production. Tensions in Africa (Nigeria, Angola, etc.) regularly lead to production disruptions. Geopolitical tensions can also take the form of economic embargos, such as the recently lifted one on Iran, which led to reduced output globally. Disruptions can also be the result of technical issues. Most production facilities experience such issues and they may have a strong impact on shortterm price movements.

In addition, oil price is partially controlled by how the OPEC countries regulate their oil outputs. Although not widely respected, the system of production quotas shared among the OPEC members influences overall production output. Saudi Arabia, being the first producer in the world, as well as the cheapest source, has been in recent years the main factor of production adjustment. Regulating production up or down has influenced significantly the oil price level. While regulating down production helps increase prices, this makes it difficult for OPEC countries when it comes to regulating down prices, due to a reduced free production capacity.

Finally, oil production obviously depends on the production capacity and the depletion of reserves. Proven developed reserves correspond to fields already in operation. The price to produce one more barrel is called the marginal cost of production. The marginal cost of the last barrel to be produced to meet demand is thus a key indicator for setting oil price. Below the marginal cost of production, producers start to shut down fields as it becomes uneconomical to operate them, and the remaining fields progressively get depleted. When demand continues to grow, it becomes essential at a certain point in time to restart fields or to develop new reserves (retrievable) to balance offer and demand. The price at which the fields can be restarted or the retrievable reserves be developed and made productive is, however, much higher than the marginal cost, as it takes into account the return on investment for the operator. The breakeven price for the operator (or incentive price) in an uncertain market is thus a key factor to restarting production in order to meet demand. Restarting a field is less costly than developing a new field (BNP 2015). The typical payback for investments in new fields averages 8 years, with the notable exception of shale oil in the United States, for which payback is only 2 years. An accurate and sustainable oil price level is extremely important to trigger the massive capital expenditure investments that the development of a new field requires.

To sum up, oil price depends upon a multiplicity of factors. Some will affect short-term oil price variations, such as:

  • - oil inventory levels
  • - short-term unplanned production disruptions (technical, geopolitical)
  • - spare capacities of OPEC countries and their capability to regulate output
  • - marginal cost of production

while a few other factors will influence oil price variations in the mid-term:

  • - consumption demand evolution and its responsiveness to oil price evolutions
  • - the economic soundness to develop new production capacities to renew depleted reserves

These two oil price variations cycles obey different rules, and must thus be looked at separately.

In conclusion, the difficulty in forecasting oil price relates to the fact that despite the market being a global and well-organized one, the data needed to accurately forecast the behavior of the various market players is often missing. The amount of proven developed reserves is generally not transparently communicated. Reserves are often estimated but not accurately known. The marginal costs as well as the breakeven costs are also not accurately known and shared. This lack of transparency generally leads to wrong interpretations. Production disruptions, especially when they are of a technical nature, are difficult to predict, although they have an important impact on the final price. Forecasting oil prices is thus an imperfect exercise.

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