What drives the price of oil

Understanding the oil market with its roller coaster

Once again, since the beginning of this year, we have witnessed a sudden drop in the price of oil, which in a few weeks has lost about 75% of its value, falling from around $ 70 to just over $ 20 per barrel. Note that the drop in price is antecedent to the present economic crisis due to the coronavirus pandemic. 

Barrel prices and Dow Jones

The first question that arises is whether there has been a strong excess of demand with respect to the offer, that is, whether it has been produced, or better exploited from the Earth, too crude compared to its demand in the world market? Or perhaps the price depends on many factors and is not simplistically referable to a balancing factor and continuous readjustment between supply and demand in the market.

Looking at the graph we can see that:

The prices of the three oil's index prices almost always follow the same trend in detail with similar values, despite being extracted from three geographically different areas, characterized by very different operating costs (OPEX).

The fluctuations between quotations of maximum and minimum values are much greater in percentage than those observed on the Dow Jones curve, the largest falls in the values are sudden, while the rises are more usually more gradual.

The correlation between barrel trend and Down Jones trend is only possible over short time intervals.

The positive price trends are not due to the  much discussed oil production peak, which has so far proved to be non-existent, but rather to international tensions involving the main areas of extraction of black gold.

The effect of the arrival on the market of oil from shale and tar sand (also known as bituminous sands) has been observed with a delay compared to the first productions, but now it is seen and has allowed the USA to return to being energetically independent and also oil exporters. They will probably export little, but psychologically it is an important fact.

Another consideration: to date, the use of oil is indispensable to many economies and not economically replaceable in the short term, so that this commodity is purchased even when it has high prices, for this reason its price is not quickly calmed down by competition from market with additional offer of oil from producers to acquire new buyers, because they know that their regular buyers must buy and therefore also maintaining high prices continue to sell and earn without price war.

Vice versa, when the price is low, those producing countries, to which petrodollar revenues are essential for the life of the country, find themselves in the need to try to maintain a constant cash-flow, so they try to remedy the fall in the revenue per barrel with the sale of additional barrels, triggering a mechanism for maintaining low prices and a war between producers.

The price of oil has quickly dropped in the face of severe economic crises that have severely reduced demand, or because of the cumulative action over time of the entry of new producers such as the American oil shale, the return of strong producers such as the Iranians after the end of the embargo to which they were subjected, the production of Russia whose plants in the oil fields are no longer penalized by the legacy of the old Soviet technology.

Perhaps in a few years historians will be able to better quantify the downward effect that the smuggling on the market of low oil prices sold by ISIS had on the market, and probably the economic motivation for which Putin wanted to enter so heavily in Middle East and fight the caliphate will be better understood .

Finally, to whom is the present strong drop in the barrel harmful?

Without a doubt it harms those who want and look for the energy transition in freeing themselves from "fossils", overall the green alternatives were often already uneconomical with the barrel at $ 60, if they had not had subsidies and other government subsidies.

American producers will now have to show their resilience, and we often forget that they produce in the country where the extracted liquid is less taxed, therefore low numbers in the sum of operating costs and taxation, so perhaps many still manage to have a small margin of earn.

It will greatly harm the entire service infrastructure for the oil industry, with the loss of jobs, the closure of specialist companies in the sector, and the dispersion of technological know-how and experience. It is possible that the next recovery in the cost of the barrel will become more difficult for the coupling of this industry, at which point it will be easier for the much requested energy transition towards a green economy to really start to take hold. But we will not have cheap energy, I would say that it will cost us as if the barrel had returned to its all-time high.

What do you think? Do you agree with this evaluation?