Emerging Factors Driving Oil Prices
October 2010
Overview
We reviewed a variety of traditional factors that have affected oil prices (e.g. supply, demand, inventories and OPEC spare capacity levels). However, within the last five years, new emerging factors (set out below) have had a growing influence on oil prices.
In this section, these factors are identified and briefly explained. In sections to follow, we will track how these emerging factors help explain the crude oil price changes since 2000.
Repeal of the Glass-Steagall Act and Financialization of Oil Markets
With the repeal of the U.S. Glass-Steagall Act14 in November 1999, banks and other institutional investors (investment banks, hedge funds), increasingly participated in risky investments such as the crude oil and gasoline futures markets. According to many analysts, this new “market” for crude oil futures had a significant impact on crude oil prices.
Asian Oil Demand
One of the most dominant factors contributing to crude oil prices after 2000 was the sharp rise in demand for oil from China and other Asian developing nations as shown in figure 2, China and other Asia demand accounted for most of the global crude oil demand growth between 2004 and 2007, and about 40% of growth in 2008.
Figure 2
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Oil Price Subsidies
An International Monetary Fund (IMF) survey of 42 developing and emerging market countries including China, India and the Middle East found that less than half fully passed through higher world oil prices to retail customers in 2007. This subsidization reduced the incentive to conserve and contributes to rising oil prices by sustaining oil demand in the face of relatively high crude oil prices.15 In many countries, the retail price of diesel fuel, a refined product made from crude oil, is less than the price of the crude oil used to make diesel.
Figure 3
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Hypersensitivity to Geopolitical Events
While there is nothing new about geopolitical events affecting oil prices, what is new is a sense of hypersensitivity to geopolitics particularly among new traders who have gained increasing influence over the oil market with rising financial investment. To illustrate, while the 2007 Israel Lebanon war did not disrupt oil supply, it had a significant upward influence on oil prices. Similarly, threats made about cutting oil supplies by Venezuela in February 2008 also influenced oil prices even though there was no physical impact on oil supply.
National Oil Companies (NOCs)
Prior to the 1970s, seven international oil companies (the “seven sisters”) dominated world oil production At their peak, the seven sisters controlled almost 80% of world reserves, production, and refining capacity outside of the United States, Canada, and the Communist Block. In figure 3, the NOCs are striped. Figure 3 shows that in 2007, roughly 78% of world oil production was produced by only 50 companies, and about 52% of global oil production was controlled by state-owned NOCs. This dominance has had several effects. First, it encouraged the previously mentioned hypersensitivity to geopolitical events. Secondly, it contributed to crude oil price uncertainty, as commodity investors were more concerned about the timely development of required crude oil supply, given that more and more of the world’s supply must be developed by NOCs.
The Declining Value of the U.S. Dollar
Oil is priced in U.S. dollars and changes in the value of the U.S. dollar influences crude oil prices. The recent decline in the value of U.S. dollar against the Euro (illustrated in figure 4) has played a role in rising oil prices. The Euro rose 78% against the U.S. dollar between January 2002 and July 2008. This corresponded to a peak in oil prices.
The decline in the value of the U.S. dollar is of particular concern to Middle East members of OPEC who purchase most of their consumer goods in Europe. In recent years, OPEC has raised its opinion as to what it considers an acceptable price for its crude oil. The decline in the purchasing power of the U.S. dollar, over the last decade, offers a key explanation for why OPEC has pushed for higher crude oil prices.
Figure 4
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Disappointing Non-OPEC Production
In recent years, disappointing non-OPEC production raised concerns about oil supply and this contributed to increased oil prices.
Within the last decade, the former Soviet Union (FSU) countries accounted for virtually all of the net growth of 5.3 million barrels per day (Mb/d) in non-OPEC production. It is clear that without the FSU countries, non-OPEC production would not have increased. As FSU oil production growth rates slowed (FSU crude oil production was flat in 2008), concerns about growing dependence on OPEC raised concerns about oil supply and prices rose in 2008. Furthermore, non-OPEC production from the North Sea declined by a third between 2000 and 2008, and production from Mexico’s largest oil field, Cantarall, declined by half between 2004 and 2008. Oil traders bid up the prices of oil as they become more concerned about the world’s increasing dependence on OPEC production.
Gulf of Mexico Oil Spill
The bill for cleaning up the April 2010 Gulf of Mexico oil spill could be more than $10 billion. However, this cost could be small compared to cost the disaster adds to producing offshore oil in the future. Given the importance to global oil supply,16 few experts expect offshore drilling to be halted or sharply cut. A tightening of regulations and higher insurance premiums could add significant costs to finding and developing oil in deepwater17, which could push world oil prices higher.