Price fluctuation in crude oil is really amazing

Written by fe Bureau | Updated: Jun 8 2010, 05:09am hrs
In December 1998, crude oil prices were around $10 per barrel. Almost ten years later, in July 2008, prices touched $147 and once again saw a precipitous crash which stopped only at $33 only to rebound once again to $86 in April 2010. As I write the article, it is $70 in mid-May. In fact, the last one year has seen crude oil rise 10% but from January 2010, we are down 15% in May.

Now that is what I call volatility! And it only seems to get better or worse depending on which side of the petrol-pump you are on. So, is there a way to predict where it will be after a year or two A quick poll among my network threw up answers as varied as $30 to $130. So lets go through the reasons which make crude oil prices move and try to figure out the most likely outcome.

The last five years have seen choppy waters; it had been a steady climb with a graph that looked like the rising side of a hill followed by one of the steepest falls in memory. When asked, many market players are pushing their own agenda. So as expected, Opec continues to have a hawkish stance. And why not They produce 35% of the worlds oil, most of it is exported to the developed and the developing world and their production costs are in the low single digits. Therefore, that could just be positioning from a potential beneficiary.

One major factor affecting prices is geopolitical instability; periods of tension have always resulted in higher prices and its hard to tell when the next stress point will show up. But surely were not headed for a more peaceful world in the foreseeable future, and certainly not in the countries which hold much of the worlds oil wealth. So oil prices will fluctuate and there will be spikes on both sides of the median.

Then there is the ingenious argument that the world is running out of oil. Well, that has been true for the last 40 years but with a caveat. On an average, the reserve:replacement ratio has been hovering around one i.e. equal recoverable reserves have been found under the ground than the typical consumption in a year. It may also be true that spare global capacity (the amount of incremental oil that can be brought to the market quickly) is a function of technology and there has been considerable progress on that front. Also, the investment of the last few years will create enough refining capacity to force fuel prices downwards. One of the reasons that prices rose sharply in the last decade was due to the refining bottleneck i.e. low crude oil prices in the 1990s ensured that little investment was made in refining capacity and the effect was clearly visible when demand started rising.

The one real concern today may be that oil fields are ageing, there have been no large finds in decades and it is estimated that over 75% of the oil produced today comes from oil fields older than 20 years. So a large oil find by a non-Opec country may yet be the best way to inject competition into this industry for saner oil prices.

Then there is the alternative fuels story. There have been no unqualified successes so far simply because the cost of the alternatives is more than the cost of crude oil itself. But pushed to the wall, you can be sure that oil-dependent western economies will definitely find alternative sources of energy. For them energy equals freedom and lack of energy will equal anarchy; so the stakes are too high for them to not find an alternative source when they have to even if it costs more than crude oil but is within their control. Also, after the oil-shock of the 70s, per capital oil consumption has fallen globally as conserving energy and small cars became popular. So consumers will respond, even if there is a lag.

Arguably, most of the price increase has been based on speculation and ability to pay rather than transparent fundamentals. The Opec is basically a club of 13 countries out to get as much profit as possible in the shortest possible time. They are simply trying to get their share of the worlds new found prosperity. There is no shortage of oil and all demand is being met, comfortably so far.

The prices increases seem to be simply a function of what the market can take. Of course, history has shown time and again that there is one level where the relation between demand and price does not remain inelastic and the consequent degrowth leads to a downward spiral i.e. a fall in demand followed alternatively with a fall in price. Of the 86 million barrels produced every day, about 30 million barrels are produced by the Opec member countries. An increase of $10 per barrel converts to more than $100 billion of additional income in a year! No wonder they try to talk it up and this talk is not cheap! This explains why it is so difficult to convince them to increase production just so that prices come down. Other large producers like the US have limited effect on prices because they are net importers.

Another factor to spook crude prices is a strong dollar which is a scenario unfolding right now even as a US battling recession is faring better than a Europe, which seems to face a newer and bigger crisis every day. All these factors make for serious uncertainty and all markets react to uncertainty by converting it into volatility which is the reason for the violent price fluctuations in the last few years. Excess volatility has also made it a paradise for speculation. Purely on demand-supply dynamics, crude oil would sell for around $20 a barrel i.e. a cost-plus situation without the gobbledygook of the Opec, global security scenario and currency play. But the dominant factor will be the performance of the global economy, which today looks iffy at best.

In fact, I am willing to take a (small) bet that we will see $30 a barrel before we see $130 on the trading screens.