The price of oil

22 March 2012. Question: While oil and gas prices seem extremely high right now, in my recollection gas prices go up every summer.

Prof Dr Reto Föllmi: That’s true. Gas prices have always – at least it has always been so in the past that they are linked contractually to oil prices.

Q: So how is the price of oil set? There is a lot of talk about local production vs. foreign, importation and speculation. What are the actual factors?

Föllmi: In a sense it’s part of all these factors. It’s a typical commodities market, where you have the producers – mainly located in the Middle East, but in other continents as well – and you have different qualities of oil. However, all their prices mainly move in a similar way no matter the quality.

Now what are the main drivers? Well of course you have supply meeting demand as the main drivers. Supply side must consider changes in supply, and of course anticipated changes in supply, because the price is always forward looking. If, of course, you know the supply tomorrow will be lower, and you can store it, then the price today will react immediately. So rising tensions with Iran implies that supply could be more limited and we see a rise in price today.

Q: When you say “forward looking” is that what is meant by speculation?

Föllmi: The term speculation seems to have a negative connotation these days. Speculation is like taking a bet. However, if you know in three months that many oil producing sites are going to come back on line, and you know this for a fact, then it’s not speculation to adjust the price. That’s simply forward looking.

Speculation is still based on the information you might have, but the risk is much higher. It’s like making a bet. You may think that, on the demand side, the economic recovery will be very strong so you bet on increased demand and a rising oil price or vice versa.

Q: I’m curious what would be the factors that would encourage you to bet that the price of oil will lower, because whenever prices spike they never really seem to reset down to the starting point.

Föllmi: In recent years, yes. But of course two things you should keep in mind. First, if you go longer back in time. Oil prices really went down a lot after the second oil price shock in the nineties. The second thing is inflation. If you remove inflation as a factor you see that the really big swings tend to go back to about where they started. Of course, I’m talking about the past; we don’t know now where the prices will stay.

There are reasons why in the very long run prices should rise in my view. That’s simply because of the increased growth of the world economy, and many new emerging markets. China for instance and India as well have now grown so much that they need a lot of oil for their production. Second is that the cheap oil production sources are finite in some sense. As these start to run out we need to use more complicated means to extract oil which affects the price.

Q: The fact that China and other developing markets need more oil seems like a logical reason for prices to rise.

Föllmi: Of course that’s a long run explanation, looking about 10 or 20 years down the road.

Q: Okay, but in more immediate times it seems just the talk of a future conflict with Iran and in the Strait of Hormuz has spiked oil prices.

Föllmi: Well the price is dependent on your expectation of future supply and demand. Now if there is new information, or at least gossip or rumors about the possibility of a war where we know supply will go down because the Strait of Hormuz will be under conflict, this raises the expectation or the perception that war could happen. If the perception goes from a 1 per cent likelihood to 10 per cent likelihood there is still a 90 per cent probability that it won’t happen. But the price reacts to the overall average.

The fact that it’s 90 per cent likely not to happen still means 10 per cent chance that oil supplies will be cut, and the price reacts today. Then of course if war does break out it’s 100 per cent likely the oil supply will be at least temporarily cut off, and prices will react again.

Q: Let’s look at it from the other direction. There is a possibility of war and the price goes up, then tensions cool and the price rests at or near its original price. In the meantime it seems as though people were making a lot of money off of the possibility of war without there ever being any actual effect on the supply.

Föllmi: Yes, that’s expectation management. Of course there are immediate winners from these times – particularly oil producing countries – because they have a higher price on their product. The second group might be people who would create the rumors themselves and cash in. Now people have the impression that this happens, but especially in the oil market, which is really a global market with many buyers and many sellers, getting a small group of people creating rumors is much less likely than in a smaller market.

Also, it’s unclear what the incentive would even be for the oil producers because they are in a long-term market. They don’t want the price of oil to fluctuate too much because they are interested in a steady income. Because if the oil price goes up too much and is very volatile – and you can easily see this in the data – oil consumption goes down. In particular because new energy saving technology research and development pays out much more when oil prices are consistently high.

You saw that for example in 2008 before the financial crisis, when oil prices spiked, and you saw that SUV sales dropped, because they use so much fuel.

Then the funny thing is that during the actual financial crisis, you would think that these types of cars would still have low sales, because they are expensive and less fuel efficient. However, they are now very popular again. Why? Because the price of oil had gone down.

Photo: Photocase / alphoxic