In general, oil prices are volatile in nature and there are several factors which influence oil prices. This is also witnessed by history. Like other commodities oil prices are also dependent on demand and supply. However, there are also other factors which also play roles in determining oil prices. This section will focus on the history of oil shocks and the traditional factors which influenced the oil prices. In addition, this section will also describe emerging factors affecting oil prices (Hamilton, 2010).
Back in 1850 people used traditional old methods to obtain oil such as extraction of oil and gas through coal but by the passage of time new techniques and methods were introduced. In 18th century people used to produce illuminates through gasser and downer processes, but later oil was discovered as an efficient substitute to produce illuminates. In 1859 the first oil well was drilled in Pennsylvania which was a far more efficient way to obtain oil in large quantity than the traditional method to process coal in order to get oil (Hamilton, 2010).
The first product of the well was sold at a price of 50 cents per gallon and the price for oil is generally given $20.00 per barrel from August till the end of 1859. Due to increase in production of oil from the Pennsylvania field, the price of oil started falling and reached an average of $9.60 per barrel. During the period of 1860-1861 where exploration of oil was on peak, the production rose from half a million to 2 million barrels per day. As a result of an increase in production there was a fluctuation in prices which resulted decline in prices from $9.60 per barrel to $2.00 per barrel (Hamilton, 2010).
Historically the first oil shock occurred during 1862-1864 which was an era of civil war in the United States of America. During the time of civil war there was a scarcity of different commodities including oil. Beside the civil war there was another factor which was also leading to an oil price fluctuation and a shortage which was a waterflood which resulted decline in production and a naturally shortage and increase in prices (Hamilton, Historical Oil Shocks, 2010).
After the end of the U.S. civil war, or in other words, from 1865-1899, new areas in Pennsylvania were discovered for drilling, which increased the oil production. Beside the U.S. oil fields, Russia was also producing a significant amount of oil during the same period and these two markets were open for a world access. In addition, new technologies and advanced methods of oil exploration were also invented which not only improved the production but also the reason of lowering down the prices. In 1892 once again the price reached 56 cents per barrel. In the post war era of 1865-1899 the demand of all commodities went sharply down (Hamilton, Historical Oil Shocks, 2010).
1.1 Establishment of The OPEC:
The Establishment of the OPEC occurred in 1960. It came into being during the Baghdad conference where Saudi Arabia, Venezuela, Kuwait, Iraq and Iran became the first five founding members. Later in 1971, the OPEC was joined by other members including Indonesia, Libya, Qatar, United Arab Emirates and Algeria. The objective of OPEC was to develop synchronized policies to minimize the risk of the price volatility for oil producers and safer platforms for investors. Since the formation of the OPEC, it has great control on the global oil industry. Before the formation of the OPEC, prices were set by Texas Railway commission (Hamilton, Historical Oil Shocks, 2010). But after the formation of the OPEC, prices were set by the OPEC, because of the pact among the majority of the oil producing countries (OPEC, 2017).
1.2 Arab Oil Embargo:
The aim of the OPEC formation was to ensure a price stability amongst the oil producing countries. At the time when Egypt and Syria started a war against Israel, many of the western countries supported Israel (Affairs, n.d.). President Nixon (United States) seeked $2.2 billion from the congress to help Israel in the war. Many of the OPEC member countries made alliance with Iran, in order to stop the supply of oil to the U.S. and other western countries which resulted in a shortage of oil in the U.S., where demand and prices went on a peak of $12 per barrel. The act of the OPEC was enough to show the world its significance and dominance over the global oil market.
On the other hand, the U.S. decided to put an embargo against the OPEC in 1971 when President Nixon took the U.S. off of the gold standards. A gold standard means when a paper currency can be changed with the amount of gold, which is available in the country’s reserve. The decision of shifting a currency dependency from the gold standards, depreciated the value of the dollar. The nosedive value of the dollar affected the oil contracts which were valued in dollars and depreciated the revenue of the OPEC member countries (Amadeo, 2017).
1.3 Iran & Iraq War:
In the 1980s there was a war between Iran and Iraq which had slight impact on the oil prices. Iran and Iraq were members of the OPEC. The war amongst these two-member countries resulted in the decline of the global oil production by 10 percent and was the reason of an increase in the global oil prices. The economy of Iran was more affected due to the war, because most of its oil fields were located in the southwest of Iran which was the war zone. On the other hand, Iraqis who faced hurdles in exporting oil, have shifted their oil supply from the war affected Gulf area and found substitute in Turkey, where they allowed Iraq to lay a major oil pipeline on its territory. On other hand where the Iran was completely dependent on the gulf region. The world witnessed the event of war and also the insight how fragile and uncertain the gulf oil market was for the buyers, who were completely relying on the gulf oil market (Zeidel, 2013).
1.4 OPEC VS non-OPEC:
The oil market is divided into two groups which are OPEC and Non-OPEC countries. The OPEC is the world’s most influential oil producing group which comprises of the Gulf countries. The NON-OPEC includes Russia, the United States, China, Canada and Mexico (Ronald A. Ratti, 2014). There were several events which occurred in the past, like the Iraq and Iran war, the Arab oil embargo and the Gulf war where OPEC showed its hold on the global oil market. Furthermore, the dominance of the OPEC can also be witnessed by events which occurred in the past like the Arab oil embargo of 1973. Because of this embargo an increasing upward trend happened in the oil prices, which jumped from $ 3 to $ 11 per barrel (Matthies). The biggest crude oil producer among the OPEC countries is Saudi Arabia and it has also influence on policy making including pricing and supply decisions(Kilian R. B., 2004).
If we talk about non-OPEC countries and their role in global oil market, then questions which arise are :
Do they also contribute in oil price volatility? Do their production level also effect global oil supply?
Source: OPEC Annual Statistical Bulletin 2017
If we look at the dynamics, then it shows that 81.5 percent of the world oil is being produced by the Gulf region and the rest by non-OPEC countries. The proportion of oil production between the OPEC and the rest of the world gives us the clear answer that the OPEC countries have a greater influence on the global oil market (opec share of world crude oil reserve 2016, 2017)
On the other hand, it can be also seen that the oil consumption level of the non-OPEC countries is much higher in comparison of their oil production. Due to this fact their exports of oil are very low which makes them less dominant in the global oil market as compared to the OPEC nations. Moreover, some of the non-OPEC countries are unable to fulfil their own requirements and have to import oil from different countries in order to meet their need. The overall scenario shows how and why OPEC countries have a monopoly or dominance over the oil prices and over the supply of the world and this is the reason why this trend cannot be shifted towards non-OPEC nations. However, there were events like wars and tensions among OPEC countries, but that was temporary and could not affect the monopoly of the OPEC (Seth, 2016).
1.5 GULF WAR 1990:
The invasion of Kuwait by Iraq was another episode in the history of the oil prices. That was the time when the Gulf region just came out from the chapter of the 1980s war, and the world oil market was still adjusting and stabilizing itself (Looney, 1992). In 1990 when the Iraq attacked Kuwait, all of a sudden, the oil price increased dramatically from $ 14.9 per barrel to $ 41.1 per barrel. After the Iraq invaded Kuwait, the United Nations put an embargo on these two countries. Kuwait and Iraq are very important members of the OPEC and very rich oil countries as well, as they are holding huge proportion in the OPEC production. Due to an embargo on Kuwait and Iraq the world oil supply was severely affected. The oil shock of 1990s was not as big as the previous which occurred during the time period of 1973 to 1974 and 1979 to 1980. It was measurable, and according to some economists it was a short-term and foreseeable crisis (Tatom, 1991).
1.6 Economic Boom And Recession:
After a recession or an instability, there is always a time for an economic recovery. Events like a war always impact on the global economy. When the Gulf war was over, the global economy started to recover. Advanced economies like the U.S. improved and the unemployment rate of the U.S. fell down. We know that oil is a very essential source of energy and it has a great significance for the business world. An increase or a fluctuation in the oil prices means a fluctuation in margins and higher costs of doing business, or in other words, an increase in the oil prices means an increase in the costs of commodities and services like transportation, which is energy intensive. During the time of the gulf war, when oil prices reached a peak, the total oil consumption of the world fell down due to a high price and a low demand of goods and services. After the Gulf War, oil prices started falling because of an improvement of supply. Besides that, global oil demand also increased and reached up to 6.2 million barrels per day.
For instance, oil consumption in Asia reached up to 300.000 barrel per day, which was granted to a price recovery that extended to 1997. On the other hand Russia also contracted its oil production to 5 million barrel per day which was a very big aid in the price recovery process.
OPEC production decision always has a significance on global oil prices. The increase of the production of oil from 2.5 million to 25 million barrel, effective from 1st of January 1998, was a blunder of the OPEC, through which it lost control over the production discipline. However, there was a sharp decline in the growth of the South East Asian economy and for the first time in the history of the South East Asian economy since 1982, oil consumption also declined. Due to the combination of lower demand and higher production of oil by the OPEC, which resulted in a declining oil price. The response of the OPEC towards a lower oil price was a reduction in its oil production by 1.25 million barrels per day in April 1998 and later 1.335 million in July 1998. The downward trend in oil prices continued through December 1998.
The OPEC dragged down its production by 3 million barrels per day between 1998 till the middle of 1999. Oil prices started to restore on a normal position and a recovering process had been started earlier in the year of 1999. During the same year the OPEC took a step to influence prices by cutting down its production once again by 1.719 million barrels in April. All the production reductions and majors which the OPEC took was enough to influence and move the price above $ 25 per barrel (Williams, 2011).
The beginning of the 21st century came up with some bad news for the US economy. The GDP (Gross Domestic Product) of the U.S. which was expected to grow by 2.8 percent, was not up to the expectations and considerably slower than 4 percent. In addition to that, the unemployment rate was kept on rising which was increased for more than 1 million jobs. Furthermore, short term interest rates which rose to 5.5 percent as well as interest rate on long term treasuries, reached to 7 percent.
The oil production itself is capital intensive and obviously requires a lot of capital for an efficient production. The recession, called dot.com bubble, which occurred during 1999-2000, did not affect the production of oil due to two major factors of that time: availability of huge capital amount and advance technology.
The starting of 21st century was quite strenuous for the OPEC. Due to a growing population of the world and a growing demand of oil, the OPEC faced several problems which included price control, cutting down quotas from different places and to make a balance in production.
During the time when OPEC was facing challenges regarding their production, on the other hand non-OPEC countries like Russia and Mexico enormously increased their production in the year 2000. Russia increased its oil production by 6.2 million to 9.5 million barrels in the year 2000. The increasing Russian oil production was an exclamation for the OPEC members, having limited production quota which was in comparison to Russian production.
The unforgettable incident which is called 9/11 Attack in New York also led to a sudden decrease in prices which jumped from $30 per barrel to $20 per barrel. The reason was a decrease in demand of oil.
In March 2003, the president of Venezuela tried to reframe the OPEC by reducing the nation oil production, so that it can manage the balance of the quota in order to earn sufficient revenue for the country (The Millennium and Present Day Production, 2016).
1.8 Emerging Factors And Oil Prices:
The transportation industry is an oil dependent industry due to which the oil price volatility matters a lot for the business. Small variation in the price of oil effects the business either in negative way or in positive way. However, there are always existences of traditional drivers which are affecting the oil prices. But from the last several years it has been noticed that there are also some emerging factors which globally play roles in the oil price volatility. Traditional drivers have always an impact on the oil prices but during the last decade there were emerging factors which also influenced the global oil prices.
1.9 Traditional Drivers:
One of the key factors of the govern oil price is the demand and supply. However, there is an existence of various elements, which always influences the global oil prices. For example: these elements could be weather conditions. Season like summers where the travelling demand is high, cause an increase in oil demand. Natural disasters like Hurricanes, which occurred for example in 2005 (Hurricanes Katrina and Rita), vandalized refineries and offshore pipelines due to which the gasoline price increased dramatically by 40 percent in U.S. Moreover, some other factors like the U.S. crude oil inventory levels and OPEC production decisions spare the capacity level, which has significant influence on the global oil prices (Natural Resources Canada, 2010).
1.10 Financialization of The Oil Markets:
One of the emerging factors affecting global oil prices is the financialization of the oil markets and now global oil prices are decided in the future oil markets. The Glass Stegall act of the U.S. in November 1999, authorized institutional investors like the investment banks and hedge funds to get involved in risky investments like crude oil markets and gasoline future markets (Natural Resources Canada, 2010). During 2007 to 2008, which was an era of a financial crisis, investments in the future of oil also caused a fluctuation in oil prices. After the U.S. Glass-Steagall Act in the year 2009, NYMEX Oil Future Trading represented the global trading volume of the world production 6 to 7 times (Natural Resources Canada , 2010).
Moreover, the function of NYMEX is to provide platform to buyers and sellers. There are two kinds of traders which exist in this market: the first type of traders are the commercial traders like refineries and oil producing companies that guarantee future prices of crude oil and other petroleum products, to put themselves on the safe side and secure their revenues. The second