Economics of OIL

Global economy is vulnerable to any event that affects the supply and demand of oil. Being the basis of all modern economic activity, it is also one of the potential causes of conflict among the economies. The politics of oil and the corrupt policies associated with it, have become endemic, and now it is a global phenomenon. It’s not just another commodity. Given this, a stable oil market is a prerequisite for an orderly global economy and steady growth.

Oil, or the black gold, as it is popularly referred to, has fascinated human kind for long. It has played a significant role in the growth of civilization and has had considerable influence in the development and prosperity of society, more appropriately, nations. Many wars have been fought for oil and it still continues to dominate the political agenda of many a nation (read: US, Iraq, and other OPEC members).

The history of oil began over five thousand years ago. Crude oil is one large group of substances, which are typically viscous liquids or liquefiable solids. Crude Oil is refined into many component parts and has many uses, apart from the obvious petrol, diesel, paraffin, bitumen etc.

Today, without oil, man’s ability to adapt to the dynamics of life will be almost nothing. In fact, everyday life would be very different, if oil had not been discovered. Besides oil products, there are various other products made out of oil usage. For example shampoo, cosmetics, detergents, paint, ink, plastics and many such products owe all or some of their key components to refined oil. In short, man’s life is literally dependent on oil for survival. There are oil reserves located throughout the world. While oil is richly spread across some geographical regions, in some regions it is short in supply, and in some others it is not found at all. Given its importance in the day-to-day activities of human life, the world economies do anything and go to any extent for oil. Those countries that do not have oil are always on the look out for it from those having it in excess.

It is estimated that 40% of the world’s total primary energy demand is fulfilled by oil. It is mostly used as an energy source for industrial, commercial, and domestic purposes. Global economy is vulnerable to any event that affects the supply and demand of oil. Being the basis of all modern economic activity, it is also one of the potential causes of conflict among the economies. The politics of oil and the corrupt policies associated with it, have become endemic, and now it is a global phenomenon. It’s not just another commodity. Given this, a stable oil market is a prerequisite for an orderly global economy and steady growth.

Oil Drilling and Politics

The current era of oil production began on August 27, 1859, when Edwin L Drake drilled the first successful oil well 69 feet deep near Titusville Pennsylvania. Inspired by this, hundreds of small companies started exploration for oil. In a very short span of time, oil has become a sought after business to many. In 1860, world oil production reached 500,000 barrels; by the 1870s production climbed to 20 million barrels annually. These developments resulted in a boom in production; then caused fall in prices and decline in profits . In 1882, John D. Rockefeller (America’s first billionaire) devised a solution to the problem of unbridled competition in the oil fields: the Standard Oil trust, which brought together forty of the nation’s leading oil refineries. Through its control of refining, Standard Oil was temporarily able to control the price of oil.

During the early 20th century, oil production continued to rise. The US produced between 60-70% of the world’s oil supply. By 1920, oil production reached 450 million barrels, causing a fear that the US was about to run out of oil. Then, the search for oil turned worldwide. Oil was discovered in Mexico, Iran, Venezuela and Iraq during World War I. After the war, there was a bitter struggle for control of world oil reserves. The British, the Dutch, and the French excluded American companies from purchasing oil fields in territories under their control. However, the dispute was ultimately resolved during the 1920s, when American oil companies were allowed to drill in the British Middle East and the Dutch East Indies.

During the Second World War, the oil surpluses of the 1930s quickly disappeared. Increasingly, policy makers of the oil industry shifted their attention on to the Middle East, particularly the Persian Gulf, which, they believed, would become the center of post-war oil production. As early as the 1930s, Britain had gained control over Iran’s oil fields and on the other hand, the United States had discovered oil reserves in Kuwait and Saudi Arabia. After the war ended, Middle Eastern oil production surged upwards. Gradually, American dependence on Middle Eastern oil also increased. By the early 1970s, the United States depended on the Middle East for a third of its oil.

As a result during 1970s, the world witnessed severe oil shortage. Foreign oil producers were finally, compelled to raise oil prices the worldover. This huge increase in oil prices, which occurred almost overnight in 1978 and 1979, played havoc with the US economy as well as the rest of the globe. Going by the waiting in long lines for short supplies, many Americans realized for the first time, how central a role energy played in the life of a nation and also how vulnerable some forms of energy were to political vagaries. These developments, especially those after the Mideast oil embargo of 1973-74 (the oil cartel, Organization of Petroleum and Exporting Countries – OPEC tries to manage the production in its member countries) increased the oil prices from $2.59 per barrel in September 1973 to $11.56 by March 1974 and resulted in a rush to diversify America’s energy base and to reduce US dependence on imported oil.

In 1980, Iraq entered into war with Iran, which resulted in the decline of oil production of both the countries. As OPEC’s intention was to keep oil prices high, it made no attempt to increase production in the face of the crisis. Thus, crude oil prices tripled from $13 per barrel in 1978 to $34 in 1981. The price shock was severe on the global economy because of its magnitude and duration. Going by its adverse impact on their economies, the predominantly oil consuming countries started energy conservation efforts and fuel substitution, which subsequently caused the demand for oil to decline sharply. In the succeeding years, the combined pressure of falling demand and rising supply eventually caused the high oil prices of 1970s to fall.

Followed by Iraq’s invasion of Kuwait in August 1990 and the start of Gulf war, OPEC attempted to bang on the global door once again. This time, however, the rise in oil prices was short-lived. Prices rose from $13 per barrel in June 1990 to $32 in October and then fell back to $14 by February 1991, because most OPEC countries decided to increase their output to maintain the needed supplies to complete the war. On the whole, during 1980s and 1990s, oil prices averaged to $12.50 a barrel and about $15 per barrel respectively, mainly driven by two important factors. The first was the rising world demand especially in the rapidly developing Asian economies. The second was technological advance, which reduced the costs of exploring, drilling and pumping, refining and transporting.

The Economics of Crude Oil

As in any other internationally traded commodity, the movements of supply and demand determine the oil prices; however, the supply is determined by a diversity of producers against the prevailing market prices. If more oil is demanded than supplied, oil prices will rise; if more is supplied than demanded, the prices will drop. In the process, prices fluctuate against supply and demand levels, which are constantly adjusted in trying to reach an ongoing dynamic balance. In the recent past, the process of adjustment has resulted in very volatile prices.

The US plays a crucial role in consuming more than one-quarter of the available global oil. Because of this, the oil prices jumped twice in 1973 and in 1979 resulting in higher energy prices and eventually leading to severe recessions in 1975 and in 1980-82, respectively. On the supply side, the OPEC is a dominant player in the world oil supply. In the early 1970s, the rise of OPEC and its impressive initial success in setting global oil prices ruled the market virtually, which resulted in extreme profits.

Higher oil prices hurt the global economy by driving up the prices of everything, from diesel, gasoline and petrochemicals etc. All the big oil hikes in the past resulted in economic recessions as they generally weaken consumers’ ability to spend on other things and raise costs of businesses. History suggests that sustained oil price rises have a huge negative impact on economic growth. The continuation of oil prices in the 1990s affected to end the long boom which, in the US and parts of Europe and Asia, turned into recession. This explains why the recent surge in prices has alarmed the world economy.

On the world oil reserves front, as per experts’ estimates, the world contains 4 trillion barrels and approximately half of this is recoverable. The world has already consumed 465 billion barrels of oil. Going by the current rate of 22 billion barrels per year, the world has about 45 years left to enjoy the luxuries that oil provides. On the oil reserves front, the OPEC cartel, an organization of 11 countries holds nearly 80% of the world’s proven oil reserves and over 40% of currently available production capacity. In the OPEC cartel, Saudi Arabia contains 25.3% of known supplies and it is in a position to influence global oil prices. After Saudi Arabia, Iraq occupies the second position with total reserves of 112 billion barrels of oil, which accounts for 9.5% of the world’s total oil reserves. There was time when Kuwait had more than 10% of the world’s total oil reserves. However, when Iraq invaded Kuwait in the Gulf war of 1990, it lost the position as nearly 5 billion barrels of oil were burned.

Though OPEC controlled for nearly three decades oil prices in the world, the 2003 war of Iraq has changed the fundamentals of the industry. Now, a revitalized Iraqi oil industry will pose new challenges for the mighty OPEC. It is on the verge of losing its ability to set world oil prices, a power known in economies as a price leadership. If its market share drops below 30%, the dominance could officially become a mere relic of the past.

Conclusion

Industry experts observe that oil prices, as known today, are not due to the result of a market mechanism. The current levels of higher oil prices are the result of cauterization by the OPEC members. If we were left to market forces alone, oil would be selling at $3-$4 per barrel even today. It has been seen in the past that, whenever there had been a glut in the oil market, the members launched production wars, i.e., they produced more than they were supposed to under OPCE quotas. This kind of production wars would worsen the glut and reduce price even further. Oil experts suggest that OPEC members are required to produce only an agreed quota of oil to keep the price moderately high to make good profits, but not high enough to force the west to seek other suppliers. 

Stability of the oil market will continue to depend on the ability of OPEC to control production and of course the constancy of the Persian Gulf region. Going further, oil companies have little to worry about oil demand, which is steadily increasing. In case the production is not increased the prices will definitely rise.

N Janardhan Rao, Lead Economist