August 23, 2019

Oil Price Watch 15 October 2011

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Welcome to this run of the Oil Price Watch!

Over the next few weeks we will be monitoring what has been happening to this crucial market and try to explain why the price has been moving the way it has.

The main objectives are two-fold. First, to try to get a better understanding of how this crucial market actually works in practice and how it responds to the various events and shocks around the world, real world economics in action. Second, to see how the principles of supply and demand actually work in practice and how these basic tools can help us make sense of what can otherwise be a confusing mess of data and puzzling behaviour. If it works here, it will help provide a portable skill we can apply to other markets.

This update will be a bit longer than the normal ones, just to help us set the scene. So what can we expect to see in these updates?  Basically we shall try to relate them to the various issues in the Oil Price Overview. Issue 1 (Intentions) and Issue 2 (Inelasticity) will be there lurking in the background, but more often inferred and implicit because we do not directly observe individual intentions or inelasticity.  But that does not make their effects any less real or reduce their importance and all the time in these updates it will be crucial to bear in the mind the central role that they play in markets such as this. As far as Issue 6 is concerned, by definition since we are looking at the spot market we are just monitoring short run effects – but don’t forget the difference between the two and how the effects may be very different depending on what perspective we take.

As for Issue 5 (Limited effectiveness of cartels), we may see occasional evidence of that. How do I know? Wait until you see this week’s analysis below.

It is Issue 3 (expectations) and Issue 4 (stocks) that are likely to figure regularly in these updates. That sounds dangerously like a forecast and it is always dangerous when an economist makes a forecast, so before I get into more trouble, let’s get started.

THE WEEK TO 15 OCTOBER

The week started with a headline from the FT Monday 10th (“Oil surges on hopes of bank rescue deal”) which was all about Issue 3 (expectations). European leaders appeared to be nudging towards an agreement to rescue their banks. Just a week after having fallen below $100 a barrel (because of expectations of a global slowdown) the price rose in one day by $3.07 to $108.95 a barrel. But by the end of the week it was to rise to over $112 a barrel.

So what was happening here? The market was anticipating (or thought the probability was increasing) that the mooted bank rescue deal would lead to more benign economic conditions (and demand for oil) in the future.  The FT reports this led to a demand side effect – Issue 3(a) – with crude oil traders bidding up the spot price of oil.

Meanwhile, in other parts of the market, stocks (Issue 4) were also playing their part. The FT reported during the week that European oil stocks had plunged to their lowest in almost nine years after a wave of supply disruptions. Stocks had all been hit by the siuation in Libya, production outages in the North Sea, and sabotage in Nigeria. FT concluded that this helped explain the recent rise of Brent crude. It was not just expectations but lack of supplies for immediate delivery which had led to the price rising more than 10% in just five trading days.

So the supply curve had already been drifting left because of these supply side disruptions and now there had been a boost to demand side optimism because of the possible bank deal, shifting the demand curve to the right.  Result: demand/supply mismatch at what had been the starting spot price, with excess demand at that spot price pushing price up until equilibrium was restored (at least temporarily) at a new, higher spot price.

But I also promised above some evidence on Issue 5 (Limited effectiveness of cartels), and sure enough the FT delivered this on the 10 October as well. It reported; “In another sign of strong spot physical markets, Iran, the second-largest producer in the Opec oil cartel, on Monday joined Saudi Arabia in raising the premium it charges to Asian refiners for its crude oil”.

Why is this significant?  Because it shows the two most important cartel members responding to the spot market, rather than the market being dictated to by the cartel – and it is the latter we would expect if the cartel was really effective.

Price at end of week: $112.23 

Read the oil price overview