Oil Price Analysis: The Impact Of Supply & Demand

Source: http://www.investopedia.com/articles/investing/100614/oil-price-analysis-impact-supply-demand.asp

In the long run, oil is about as purely elastic a commodity as there is, every movement on the production and consumption sides reflected in the price. We’re not discussing diamonds or caviar, luxury items of limited utility that most of us can live without. Oil is abundant and in great demand, making its price largely a function of market forces.

Simple Supply and Demand

The consumption side consists of hundreds of millions of us, who individually have limited power to influence prices, but collectively have plenty. The production side is a little trickier. Which nation is the world’s largest oil producer, day in and day out? The answer probably won’t surprise you: Saudi Arabia. But the very close runner-up might: The United States. America produces 11.11 million barrels a day, which is 95% of what Saudi Arabia produces. Russia is comparably close behind the United States, with no other country producing even half as much oil as any of the top three. China, the world’s second-largest economy, is a very distant fourth. (For more, see: How Does Crude Oil Affect Gas Prices?)

Capacity and Reserves

If you’re curious as to why it seems that the nations that produce the most oil and the ones most commonly identified with oil production aren’t necessarily the same, you’re not imagining it. It’s the countries with the largest oil reserves, regardless of production capability, that have great sway over the market. Saudi Arabia is also the leader in that category, with reserves estimated at 267 billion barrels. Or 62 years’ worth, if you naïvely assume that production won’t increase nor reserve estimates change between now and 2076. (For related reading, see: Why Low Oil Prices are Bad for the Economy.)

As for the United States, its proven reserves are less impressive than its current capacity. The U.S. has 26.5 billion barrels in reserve, 12th in the world and far, far behind Venezuela (211 billion), Canada (174 billion), Iran (151 billion), Iraq (143 billion) and Kuwait (104 billion). The remaining countries ahead of the U.S. include some cordial ones (the United Arab Emirates, 98 billion), some antagonistic ones (Russia, 60 billion) and some whose friendliness is tentative (Libya, 47 billion.) (For more, see: Unearth Profits in Oil Exploration and Production.)

Not Just Pumping…

Basic supply-and-demand theory states that the more of a product is produced, the more cheaply it should sell, all things being equal. It’s a symbiotic dance. The reason more was produced in the first place is because it became more economically efficient (or no less economically efficient) to do so. If someone were to invent a well stimulation technique that could double an oil field’s output for only a small incremental cost, then, with demand staying static, prices should fall.

Refining Too

One problem, and this is where theory butts up against practice. Production is high, but distribution and refinement aren’t keeping up with it. The United States builds an average of one refinery per decade, construction having slowed to a trickle since the 1970s. There’s actually a net loss: the United States has eight fewer refineries than it did in 2009. Still, the 142 remaining refineries in the U.S. have more capacity than any other nation’s by a large margin. The reason we’re not awash in cheap oil is because those refineries operate at only 62% of capacity. Ask a refiner, and they’ll tell you that excess capacity is there to meet future demand. (For related reading, see: Higher Oil Prices Are on the Way—But Just How High?)

OPEC: Only So Much Influence

Then there’s the problem of cartels. The Organization of the Petroleum Exporting Countries was founded in the 1960s to, although the organization’s charter doesn’t state this explicitly, fix prices. By restricting production OPEC could force oil prices to rise, and thereby theoretically enjoy greater profits than if its member countries had each sold on the world market at the going rate. Throughout the 1970s and much of the 1980s, this was a sound if immoral strategy for OPEC.

To quote P.J. O’Rourke, certain people enter cartels because of greed; then, because of greed, they try to get out of the cartels. According to the U.S. Energy Information Administration, OPEC member countries often exceed their quotas, selling a few million extra barrels and knowing that enforcers can’t really stop them from doing so. With Canada, China, Russia and the United States as non-members, OPEC is limited in its ability to, as its mission euphemistically states, “ensure the stabilization of oil markets in order to secure an efficient, economic and regular supply of petroleum to consumers.”

The Bottom Line

With demand moving accordingly every time, oil prices will continue to be set mostly by the market — despite external players’ best efforts. (For related reading, see: How Oil ETFs React to Falling Energy Prices.)

Article 2: Demand, Supply and Oil Prices*

3rd September 2015

Oil Price Analysis: The Impact Of Supply & Demand

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