The involvement of the financial markets in the modern economies and the oil market is such that upwards of 60% of the crude prices are not determined by the supply and demand forces on the markets. Instead, leading hedge funds and banks, through the international oil exchanges in London and New York control the spot prices through oil futures (Rich, Streitfeld, & Rampell, 2011). This has effectively crested more scope for speculation within the industry, which when coupled with the emergency of bond markets across the world, the scare of the exchanges markets losing an actual backing of the actual markets has arisen, with dire consequences on the predictability of oil prices. These have an ultimate effect in the economies of countries across the world. This paper seeks to assess the effects of the international oil prices on the US’ domestic economy as well as the economies of other nations across the world. The assessment includes an understanding of the role of speculation, oil exchanges, producing nations and other agents of the fuel prices, as well as the effects of their respective decisions on the consumer demand (Rich, Streitfeld, & Rampell, 2011).
International Oil Prices and the Domestic Economy
The 1988 collapse of the OPEC administered system of pricing led to the emergence of the prices freely determined by the forces on the markets, which has survived to the present-day. The nationalizations of oil reserves and the collapse of the concessions system deprived multinational companies of the influence they enjoyed in determining the oil prices, leading to the emergence of exchanges and deals outside the horizontally and vertically integrated corporations. This was strengthened even further by the rising influence of non-OPEC producers, which in turn led into the development intricate markets across the world, including physical forwards, spot markets, options, futures and derivatives’ markets. The 24-hour trading and electronic markets, enabled by the rise of technology allowed greater access to the markets and with, multiple trading instruments. Under the new system, physical deliveries occur both through spot markets and futures, with the spot markets comprising a minority of the transactions because of the logistical difficulties associated with spot deliveries (Tang & Wei, 2010).
Crude Benchmarks and Pricing
Long-term contracts stem from bilateral agreements for the delivery of crude oil shipments at pre-determined prices. The varied qualities of crude attract equally varied premiums (benchmarks), where the prices are determined by the price differential (D) and the benchmark crude price (PR). The price agreement for a spot or futures market involves agreements on the price differential (Fattouh B. , An Anatomy of the Crude Oil Pricing An Anatomy of the Crude Oil Pricing An Anatomy of the Crude Oil Pricing An Anatomy of the Crude Oil Pricing An An Anatomy of the Crude Oil Pricing System , 2011). The price differentials built in the Gross Products Worth of refining crude, rendering them hugely variable owing to the varied qualities of crude oil and perhaps most importantly, due to the changes in the relative supply and demand forces on the market for each variant of crude. In the recent three years for instance, the price differential between Arab Heavy and Arab Light crudes increased to reach upwards of $15 a barrel, with fuel oil being heavily supplied, despite the fact that diesel, which results from Arab Light’s saw shortages in the market (Fattouh, Kilian, & Mahadeva, 2011).
Benchmark differentials on the other hand are determined by the oil exporting nations, in consideration of the Gross Products Worth of the crude variant, announced up to a month prior to the loading of the products. The determination of the benchmarks builds in multiple lags, coupled with the use of dated figures, which in turn implies that the prices would least reflect the actual conditions on the market. Other nations, including Qatar and Abu Dhabi simply announce the Official Selling Prices, based on the Dubai-Oman Benchmark pricing system. Countries must not only ensure competitiveness of their crude, but also build into their pricing models the differences with between the reference and their own crudes (The Economist, 2009). In addition, oil producers delay announcing the differentials in order to reduce the lags, while also avoid being undercut by their respective competitors.
Changes in the global oil prices have far-reaching effects on the domestic economies of all countries, and the fact that countries have little control over the changes in prices, makes the changes necessarily hurtful to the domestic economies. Since the beginning of 2010, commodity prices across the world have risen considerably, following a near 40% increase in the prices of oil. The international increases in the prices of oil occurred towards the close of 2010 to 2012 with the consequential cost-push inflation on the prices of basic commodities including food, metals, agricultural commodities and minerals across the world (Fattouh B. , The Drivers of Oil Prices: The Usefulness and Limitations of Non-Structural Model, the Demand–Supply Framework and Informal Approaches, 2007). In addition, the demand for oil is dependent on not only the United States economy but also all other economies in the world. The demand of major emerging economies including China, Brazil and India, which effectively pits the interests of different countries against each other, with the consequent increases in prices, in the event the demand of the world goes up.
The recent growth in demand from China has resulted in global increases in fuel prices and the prices other commodities. The energy demand outside the OECD also contributed to the rapid depreciation of the United States dollar, with dire consequences on the ability of the country to import important resources into the country, while at once rendering its exports relatively cheaper (Ripple, 2008). The consequences of the (i) increasing oil prices and (ii) the fluctuating nature of the prices on the domestic economy are dire, with analysts estimating that a $10 increase in the price of oil is capable of reducing the GDP growth by more than 0.5%, within the OECD. In addition, a similar increase is estimated to lead to upwards 0.2% increase in the rate of inflation within the OECD, even with the multipliers used in these models ignoring multiple dynamic effects (The Economist Intellegence Unit, 2012).
Other than the actual increases in demand for energy across the world are unsurpassed by the geopolitical issues that have a disruptive effect on the real supply, coupled with changes in the market dynamics. The spare production capacity of Saudi Arabia is insufficient to meet the fluctuations in the supply of other oil producing nations that may be disrupted by political and regional tensions (Tehran Times, 2012). Effectively, the demand and supply forces in the domestic economy are unrelated to the demand and supply forces within the domestic economy, effectively rendering them either too high or too low, for a domestic equilibrium to be reached.
Formulae pricing is founded on the key physical benchmarks, including the West Texas Intermediate (WTI), Dated Brent, Dubai and the ASCI price (Fattouh B. , The Drivers of Oil Prices: The Usefulness and Limitations of Non-Structural Model, the Demand–Supply Framework and Informal Approaches, 2007). The benchmark prices are known as the spot market prices, form an important part of the pricing system, not least because producers and traders use them rely on them in setting futures prices, which have an influence on the spot market prices both at present and in the future (Krugman, 2009). In addition, benchmark crude is used by companies and banks in settlement of derivative instruments such as swap contracts. Governments and futures exchanges used benchmark crude for taxation and settlement of financial contracts respectively. Oil-producing countries use different benchmarks depending on the destination of their exports with Iraq for instance using the Brent Crude to export to Europe, while its Asian and US exports are based on the Dubai-Oman and the WTI respectively. Mexico on the other hand used a weighted averaged of varied benchmarks’ prices to determine their respective exports prices, including the WTI, the Louisiana Light Sweet, the High Sulfur Fuel Oil and Dated Brent. The benchmarks are priced through assessments by the Oil Reporting Agencies, based on the market information and assessments of the quality of oil, but the prices are strict estimates, with variation between different prices (O’Hara, 2001).
Further, while the benchmarking principle remains the same, the benchmarks have changed immensely, both in terms of liquidity and the nature of crudes involved in the process of assessment of the value. The Brent Benchmark for instance, has since began including the North Sea Streams Forties, Ekofisk and Oseberg, while Platts Dubai builds in Upper Zakum and Oman. The streams in benchmarks are naturally not identical in quality. This makes the benchmark prices not to reflect the price of a physical stream, but most importantly, to reflect the prices of a constructed index of different physical streams (Rothwell & Gomez, 2003). The benchmark crude oil streams have been declining, with far reaching effects on the market. In the United Kingdom for instance, the decline in production of Brent crude in the 1980s from 885,000 b/d to 366,000 b/d in 1986 to 1990, resulted in massive distortions, squeezes and manipulations, with the consequence of Brent crude prices being completely disconnected from other crude grades. The problem was alleviated by the comingling of Ninian and Brent crudes to create Brent Blend, coupled with the ceasing of Ninian as a crude stream. Brent Blend did not last too, and with physical production delays, came the fluctuations in the prices of crude oil based on the benchmarks. With the decline in the physical production of the crude components of benchmarks, other crudes have been co-opted into the benchmarks (Rich, Streitfeld, & Rampell, 2011). In 2002 for instance, Platts expanded its definition of Dated Brent to include Oserberg and Forties (from the North Sea) in order to facilitate the assessment process as well as the quality of deliverables in multiple forward contracts based on the benchmark. WTI has also been reported to be declining rapidly, with effects on the futures based on the index. Effectively, the declining physical production of benchmark crudes has the consequence of taking with it, the standards that form the basis of oil price determination for both the futures markets and the spot markets, owing to the huge influence of futures on the spot markets (World Bank, 2007).
While the above pricing model should under ideal conditions be functional, but the involvement of high finance and financial innovation has led to exaggerations of prices (Thorne, 2010). The Posted Pricing system that was previously used by the oil companies to set the prices of oil in consultations with the oil producing nations, and in view of the conditions on the market. In this way, the speculative forces in the market would be eliminated. In addition, the oil producing countries would be able to link the physical supplies to the actual demand in the market, effectively reducing the prospects of exploitative speculation. China has repeatedly implemented this system, with limited success, largely because of the heavily innovative financial markets and instruments in the modern world (The Economist, 2011). The Chinese model is founded on the assessment of the costs of purchase of crude oil from the oil exporting prices, including the costs of transportation and other transaction costs in order to These ensure that the role of the private sector in the determination of oil prices can never be under-estimated, regardless with the amount of regulation. In addition, the characteristic inefficiency caused by the slow reaction of governments, coupled with the time lags in forecasting models render the system heavy and impractical (Krugman, 2009).
Financial Exchanges, Physical Markets and Speculation
Upwards of 60% of oil prices are purely as a result of speculative forces by leading financial institutions, implying that while current oil prices comprise as much as $60 per barrel that derives from speculation, despite the relatively stable demand and supply forces in the previous five years (excluding the emerging economies effect). Hoarding of crude oil, and the arrival of speculative investments backed by the bond markets and securitization into the oil futures has resulted in increasing supplies, which are not passed on to the spot market but instead serve as financial instruments (Fattouh, Kilian, & Mahadeva, 2011). The potential of speculators to herd markets into supply shortages in order to profiteer is enormous, especially with the emergence of paper crude of financial derivatives, which have gained acceptance across the financial and oil markets. Financial instruments including Contract for Differences, Brent Forwards, swaps, Brent options, Exchanges for Physicals and others are now tradable on exchanges. This has in turn offered easy access, with reduced risk to instruments such as index funds, options, exchange traded funds and futures (Rich, Streitfeld, & Rampell, 2011). This has been driven by changing investor preferences in favor of market-based derivatives, which have low transaction costs and risks.
Recent studies have shown a high correlation between equity and energy returns, with the most extreme effects being evidenced in periods of financial market booms. The sub-prime markets specter (reckless risk taking due to low risks and lack of physical market bases) is evident in the non-backed markets. While it is impossible to envisage a market without securities, given the central role of crude oil on the economy, it is crucial that financial exchanges are founded on the physical markets (O’Hara, 2001). At present, most hedge funds are reeling from the collapse in profitability of the housing market, moving investments into the oil markets. This in turn fuelled a bubble in the oil market, with increases in the prices of oil futures through the period. Major companies in the European Union and North America hoarded oil, leading to appearance of oil shortages, coupled with the limit credit availability that characterized the global economic crisis. These were exacerbated London ICE Futures and Over the Counter (OTC), which are not regulated, leading to the imprecise figures regarding the dollar value of the expenditures on energy investments. This in turn created and has expanded the speculative space and incentive in the oil market, with the consequence of worsening the difference between the internationally set prices and the domestic prices.
This even most significant, with the declining physical production of benchmark crude, which would lead to a disconnect between the actual prices and the oil supplies.
Futures & Physical Markets
Both spot and futures prices are determined in response to the same economic conditions, and should by necessity reflect one another. The price set for futures closely reflects the expectations, whether real or otherwise, of the future supply and demand, which musty by construction be reflected in the spot prices (Smith & Searle, 2007). This is the sole intention of benchmarking as well as the pricing models adopted by the oil-exporting countries, which are constantly adjusted in order to fit in with the demand and competitiveness needs of the market. The futures contracts are closed by exporters and traders who resale the oil to the consumers, and to this extent, the demand and supply forces are reflected. However, similar conditions would only prevail, if the demand by the oil traders is driven by the final market needs, and not speculative demand (The Economist, 2009). Speculative demand for oil, and the relative power of financial institutions and the instruments that have emerged in the modern markets have resulted in the creation of artificial markets, which may be manipulated to the benefit of the oil traders and speculators. This occurs through artificial increases in the prices, driven by futures markets that are founded on artificially created expectations of demand and supply. In addition, even if there was no manipulation, squeezes etc, the forecasting formulae that is used to project the futures contracts pricing is independent on whether prices increase or fall (Ripple, 2008).
Further, the effect of politics and geopolitical tensions involving oil-producing nations and regions, have a greater effect on speculative and futures markets than the physical markets. While for instance the Iranian, Egyptian and Libyan crises resulted in fears of reduced oil supply to Europe, Asia and the Americas, with the consequent increases in oil prices, the actual reductions in supply have not been significant (Krugman, 2009). However, the pricing models for futures that built in this possibility in turn resulted in prices that did not reflect the physical markets. This is noticeable in periods when supply was increased by both OPEC and non-OPEC nations, which were however, not reflected by reductions in the fuel prices. The United States, which accounts for a quarter of the global oil trade and consumption, has in the recent past offered a clear example of how oil futures distort the physical trade. Traders sale the dollar short, while selling oil long, leading to a fall in the current prices at which they acquire oil and hoard, to supply it during shortages (Eicher, Mutti, & Turnovsky, 2009).
The geopolitical tensions and the prominent role played by the speculators easily masks the role played by multiple other players in the industry that however, have an influence on the spot and futures prices. These players include the oil exploration and extraction companies, the refineries and the entire petrochemical industries among others. This adds to OPEC oligopoly, which does however comprise multiple oil rich nations that compete against each other to ensure the competitiveness of their oil. Iran and Saudi Arabia’s Arab Light for instance are of the quality, land go for about the same prices (Thorne, 2010). However, the two nations must compete for markets abroad. Effectively, it is in the interest of every country to make certain that their prices are as low as possible. However, the intermediaries that deliver the oil to the final consumers have an impact on the prices beyond the control of any one player. Effectively, the international pricing system is the only viable pricing system, open to OPEC and other agents.
Benchmarks represent the most important pricing system, but ht emergency of financial derivatives based on oil, have led to the distortion of the oil prices, coupled with the lack of transparency in the industry, which has in turn resulted in the gap between the actual and the futures prices (Eicher, Mutti, & Turnovsky, 2009). A lesson from the sub-prime mortgage crisis is apt for the oil market. While the recent global economic crisis was triggered by the crush of the sub-prime mortgage market in the United States, the actual problem that precipitated the creation of bubble and the subsequent crush was the emergence of bond markets. These in turn resulted in excessive credit on the markets, with the markets actually losing the physical market back up, which were replaced with tradable securities, fuelling a bubble that ultimately haunted the global economy.
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