Let’s talk about oil – the supply and price of it. There has been a lot of banging on about oil prices lately, and its impact on prices at the pump in our homes. Politicians and media sources (especially social media) have been up in arms about it, and unfortunately, displaying a lot of ignorance about it all.
Several factors affect the price you pay at the pump to fill your car or pay to run appliances in your home. Oil is getting a lot of attention as prices soar. In December 2019, a typical barrel of oil cost about US$68. Today it is approximately US$105 a barrel and peaked at around US$125 a barrel in early March 2022. But did you know that between 14 April and 28 April 2020, oil prices were actually negative? YES, as low as minus US$25 a barrel!
So, what the heck is going on? To understand all this we need to realise that the oil industry is not like most others. There are four main features of the oil industry supply and demand, hedging, speculation, and ‘market sentiment’. These four elements of the oil market affect the supply and price in the global market, and ultimately how much you pay at the pump and for your utilities.
Supply and demand
As demand rises, or supply shortages occur, prices rise. If demand falls or relative supply increases, prices fall. At covid peak, oil demand and prices plummeted because various industries slowed considerably (airlines being the most notable, perhaps), people drove a lot less etc.
Timing is everything, as they say. As we emerge from covid lockdowns, both in the UK and globally, demand for oil and gas has started to rise again as industries pick up and people begin to travel more. Just as the world is emerging from a significant slump in demand for oil and gas, and as economic activity picks up, you would expect to see prices edge upwards.
However, you might have noticed a little altercation in Eastern Europe has flared up. Russia’s invasion of Ukraine has resulted in a significant oil embargo against Russia, and the EU is contemplating widespread reductions in Russian gas imports.
Well guess what? Russia is the world’s third-largest oil producer and second-biggest exporter to global markets. You might be surprised to know that the USA is the second-biggest oil producer behind Saudi Arabia. Russia is also the third largest source of UK oil imports (a little less than 10 percent), although most of it (both oil and gas) comes from Norway and the US. Russia also supplies nearly half of the EUs natural gas. For a look at UK energy use, you can look here.
So, as Western countries put the squeeze on Russian oil and gas supplies, you shouldn’t be surprised to see a big jump in the prices you are paying for energy at the pump and in your homes, because the global supply of oil and gas is effectively being reduced (Russia accounts for about 11 percent of world exports).
Gambling on the futures market
It gets better! Here’s where most of the commentariat display their greatest ignorance (and lousy research skills). The world’s oil prices are set by the futures market. Yes, the world’s oil prices are set by – gambling!
Basically, ‘futures’ are future contracts. Parties (investors) are contractually obligated to buy or sell an asset (in this case, oil) at a predetermined price on a predetermined date. Traders are betting on market conditions that they think will occur in the future – the near, intermediate, and longer term.
So, in April 2020 when the world was hit by the pandemic and the world started to go into lockdown, the futures markets bet that trade would come to a screeching halt and that the demand for oil would plummet (and it did); so prices crashed. Now we have a war in Ukraine that has threatened both regional and world oil and gas supplies, so, conversely, prices are rising.
The uncertainty about whether Nato will or won’t get dragged into the conflict, whether the war will be short or longer lasting, the impact that sanctions on Russia will have on not just oil and gas supplies, but also world trade, are all factors those in the futures market are betting on. Hence, we are likely to see wildly fluctuating prices that will remain relatively high for the foreseeable future.
There are basically two types of futures traders:
Hedgers are traders who are trying to anticipate and guard against future prices and price volatility. So, hedgers are wanting to minimise risk.
As oil markets in particular can be notoriously volatile, airlines are a big player in the futures market as hedgers. A stable, predictable price for aviation fuel is important to the successful operation of an airline, so they might be willing to pay a slightly higher price than the current market value, to ensure stability. Or, in a market of falling prices, they might be able to lock in a really good future price that is below the current market price.
However, most of the futures market is full of gamblers (speculators).
Speculators take advantage of market volatility – thus, oil futures are a tempting target. In other words, they are trying to ‘beat the market’.
They are betting that they can predict the future prices of commodities better than the regular market. So, it is a high-risk, high-reward environment that is also a ‘zero-sum game’ – for every winner, there is a loser.
But speculation is a difficult game to win. Think about horse racing. Most people who take a flutter on the horses lose; it’s the serious professional gamblers that make the money. They do their homework, study form etc. They are taking a more calculated risk. It’s the same in the futures market. ‘Day traders’ – Joe Lunchbox independent investors like you or me – generally lose a lot more than they make, whereas investment firms do a lot better.
The impact of human psychology
The other thing we need to consider is that futures trading (and all sorts of activity on the stock market) is influenced by human psychology, aka market ‘sentiment’. This is reflected in the language we use: the market is jittery or nervous; it’s very bullish on stock Y or Z etc.
Traders are only human, and they too react in ways that may not reflect actual market fundamentals. Consequently, we can see stock and futures markets go up and down markedly and quite quickly – the 1987 stock market crash comes to mind; the 2008 financial meltdown in America that led to the ‘Great Recession’ is another example.
So, what can we take away from all this?
- Oil prices (and hence petrol) are not primarily determined by oil companies. Shell, BP etc are not sitting in front of some big screen or sitting in a board room ‘fixing’ the price of oil. This did happen to some extent when OPEC (Organization of the Petroleum Exporting Countries) had a virtual monopoly, but those days are long gone. Do we need a windfall tax? Probably, but unless we find oil companies are deliberately reducing the amount of oil they are pumping out to manipulate the price – don’t blame them for the current prices.
- Oil prices are primarily affected by supply and demand factors. But the oil market is not like most other industries …
- Oil prices are almost entirely determined by a bunch of gamblers who operate through the futures market. This is made up of hedgers and speculators and is influenced by ‘market sentiment’. Human psychology plays a significant role.
- Things like war and other unexpected events (like the Covid-19 pandemic) can cause serious disruptions to the marketplace and with it, wild swings in the price of commodities (in this case, oil).
- We should expect oil (and gas) prices to fluctuate and remain relatively high for the foreseeable future as the war in Ukraine rages on, because this war also means a significant disruption to world gas and oil supplies and for an unpredictable duration (and traders will bet on this).
Some final thoughts
If nothing else, the crisis in Ukraine and the impact it is having on world oil and gas prices should be a reminder of our own dependence on fossil fuels is not only environmentally destructive and unsustainable over the long term, but that it makes us all extremely vulnerable to the vagaries of the world energy market. I am not naïve enough to think it’s practical to imagine a foreseeable future with zero fossil fuel use, but it does point to our need to find more sustainable, environmentally friendly, and independent sources to meet our future energy needs.
It also raises questions about capitalism and its role in the supply and distribution of the world’s resources. Is ‘green capitalism’ (complete with a futures market in ‘green’ resources) the best we can hope for?