Oil is like a wild animal, whoever captures it has it.”— J Paul Getty.
Most of the time, it’s economics that determines the price of oil, but often the price defines the economics. The volatility of our times lends its texture to the nature of oil economics. Studies and interpretations have fallen flat on occasion. And, of course, few adventitiously close to price predictions have a trail-following like the pied piper, just to vanish in the next cycle gone awry.
2020 was a downhill race for oil prices, ushering a more sober scenario in late 2021, followed by post-Covid blues in early 2022. And then came the Russian invasion, sending the bears undercover.
On May 11, Ukraine limited Russian gas transiting its territory to Europe, followed by the sanctions imposed by the European Community. On May 18, the EU announced a 210 billion euro plan to ditch all Russian fossil fuel, and oil prices continued to inch northward.
The principles of demand and supply are not the sole bearers of pricing. Greed and political motivations are equally notorious for playing up the oil scene.
Wars have been fought for oil and over oil fields as far back as the Dutch East Indies campaign of 1941–42 (now Indonesia) to the ongoing civil unrest in Yemen around the Marib and Shabwa provinces.
The opening up of China, the world’s largest consumer of oil, and a cap on Russian prices, could keep the oil prices floating above $75. As far as the recession is concerned, it seems already discounted in the prices, which leaves room for an uphill tread.
China's reopening, a mild recession, renewed spending on transportation, travel and vacationing by the three largest consumers, i.e., the US, China and India (in that order), and a cap on OPEC production, make a bullish scenario more likely. This could bring Brent back to the $100 range and WTI (West Texas Intermediate) trail around $95. These average prices may be maintained through 2023.
Two kinds of oil are primarily traded in the market:
Brent Crude originally referred to the sweet light crude oil extracted from the Brent Oilfield in the North Sea, exhausted by the turn of 2021 and consequent induction of other oil fields around this Atlantic basin, a price determinant for almost two-thirds of the world oil trade.
WTI, also known as the Texas light sweet, originated from the US and is considered lighter and sweeter with sulphur content lower than Brent. Together the two form benchmarks for global pricing and trading of oil. OPEC, holding 80% of the world’s oil reserves, 40% share in world oil production and 60% share in world oil trade, dominates as a key supplier.
However, the role of the US has evolved in the last decade as it is estimated to become a net exporter in 2023 for the first time since World War II. Oil production is often increased or reduced for reasons other than economic, resulting in a shortage or a glut. These are more of ‘motivated’ price fluctuations.
Within this ambit, it would be interesting to note that nature has contributed its own towards the supply factor. The shadow of natural calamities looms large on the price scenario. Hurricane Ian led to the evacuation of 12 platforms and two rigs in the Gulf of Mexico last September, which brought about a fall of almost 11% of US oil production per day from this region and a spike in the price of WTI.
With the world moving towards economic expansion and higher spending patterns, oil demand continues to grow. A symbiotic price rise is inevitable. Though renewables are touted as an alternate energy source, their economic viability remains under the cloud. Renewables continue to be much dearer than conventional hydrocarbons. Till the pricing and government policies are revisited, crude would continue to enjoy a comparative advantage.
Rising commodity and stock prices have historically, on occasion, led to rising oil prices. Commodities and stocks have started moving upward, breaking the trend of lacklustre performance in the last two years. As the economies expand, a sense of euphoria permeates, increasing broader market participation. Investors empirically establish long positions.
This, in turn, creates a higher oil demand fuelled by optimism translating into a price rise. The reverse holds good in times of doom. A perceived fall in aggregate demand and a sense of uncertainty lead to squaring off positions, pushing prices down.
Political or military unrest within the Middle East or one of the oil-producing nations has price ramifications. The 1991 Gulf War, the US invasion of Iraq in 2003, protracted Soviet aggression in Afghanistan, Trump exiting the Iran Nuclear deal in 2018 and, in recent times, Russia invading Ukraine, are all examples. Military adventurism (as seen in Libya), terrorist attacks at refineries leading to supply disruptions, or pricing rivalry to undermine stability are other factors. Such events tend to unveil insidiously, gradually getting factored into the price.
The world of oil is a kaleidoscope, fascinating and ever-changing. Complex as it may seem, oil pricing is not just the outcome of an economic graph based on the simple interaction of supply and demand or world politics and sentiment of the tangibility of a physical product alone. It also manifests as the fruit of speculative activities in Oil Futures and Options markets, sometimes revolving around the broad commodity market spectrum and mood.
No matter what the prices are and what determines them, oil shall continue to enjoy its dominance for a long time.
I am reminded of John Maynard Keynes: “There is nothing so disastrous as a rational investment in an irrational world.”
Ranjan Tandon
Senior Markets Specialist and author