The Future Prices of Oil

By: Sam Vaknin, Ph.D.


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How is the price of oil determined and how important it is to the global economy?

Hedging

The price of oil is no longer an important determinant of the economic health of the West.

Today, there are forward contracts, which allow one to fix the price of purchased oil well in advance. There are options contracts which can be used to limit one's risks as a result of trading in such forward contracts.

In other words:

If one loses money on the forward contract because the purchase price fixed in the contract is higher than the market price at the time of delivery (=one must pay more than the market price according to one's obligation in the contract) - one makes a profit on the options contract that is similar to the loss on the forward contract.

Thus, if one uses forwards plus options - one fixes a price in the future that can be not too far from the market price at the time of delivery. Such financial positions require sophisticated management and day to day maintenance of the forwards and options positions, though.

Fixing Oil Prices Inside Countries

Most countries in the world have three systems of fixing prices inside their markets:

  1. The price of oil and its derivatives is fixed entirely by market forces, supply and demand, usually through specialized exchanges (e.g., the Rotterdam Exchange). The market is totally deregulated - exports and imports are totally allowed and free.
  1. The price is fixed by a committee of representatives of the government, the oil industry, the biggest consumers of oil, and representatives of households and agricultural consumers.

  1. The prices are fixed every 3 or 6 months based on the cost of oil at a certain port of delivery. In Israel, for instance, the price of oil fluctuates every three months according to the price of oil delivered in certain Italian ports (where Israel gets most of its oil delivered). This is an AUTOMATIC adjustment.

  2. In other countries the prices are fixed by the competent Ministry in accordance to the ACTUAL costs of the oil (importing, processing and distribution) + a fixed percentage (usually 15%). This is called a COST PLUS basis pricing method.

The Price Trends of Oil

The international price of oil is determined by the following factors:

(NEGATIVE=depresses prices, POSITIVE=increases prices)

  1. The weather. Cold weather increases consumption. The world is getting hotter. The 14 hottest years in history have been in the last 25 years. The warmer the climate - the less oil is consumed for heating. NEGATIVE.
  1. Economic growth - The stronger the growth, the more oil is consumed (mostly for industrial purposes). POSITIVE.
  1. Wars increases oil consumption by all parties involved. POSITIVE.
  1. Oil exploration budgets are growing and new contracts have just been signed in the Gulf area (including Iraq). The more exploration, the more reserves are discovered and exploited, thereby increasing the supply side of the oil equation. NEGATIVE.
  1. Lifting of sanction from Iraq, Iran and Libya will increase the supply of oil. NEGATIVE.
  1. Oil reserves throughout the world are at a record high. This tends to depress demand for newly produced oil. NEGATIVE.
  1. The economic crisis of certain oil producers (Russia, Nigeria, Venezuela, Iraq) forces them to sell oil cheaply, sometimes in defiance of the OPEC quotas. NEGATIVE.
  1. OPEC agreements to restrict or increase output and support price levels should be closely scrutinized. OPEC is not reliable and its members are notorious for reneging on their obligations.
  1. Ecological concerns and economic considerations lead to the development of alternative fuels and the enhanced consumption of LNG (gas) and coal, at oil's expense. Even nuclear energy is reviving. NEGATIVE.
  1. New oil exploration technology and productivity gains allow producers to turn a profit even on cheaper oil. So, they are not likely to refrain from selling oil even if its price declines to 5 US dollars a barrel. NEGATIVE.
  1. Privatization and deregulation of oil industries (mainly in Latin America and, much more hesitantly, in the Gulf) increases supply. NEGATIVE.
  1. Hedge funds and other derivatives induced price volatility has increased lately. But financial players have no preference which way he price goes, so they are NEUTRAL.

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