International dynamics of oil prices in four dimensions: an analytical investigation.

• Author: Sanli, Baris
• Position: Report

Introduction

Oil is considered the world economy's bloodline. It is both an indicator and the determinant of economic growth. It is a curse and a necessity blended into a single commodity. It is a source of evil and a source of good, as prices oscillate between peaks and pits, providing new insights in every cycle. Oil price hikes and crashes are different every time and rarely anyone predicts a hike or a crash with correct timing. For the experts "it is different this time," for the ignorant "it was obvious". This eccentric nature of oil dynamics is the subject of thousands of studies. Still this very commodity is the quintessential example for those seeking to understand complex interactions between economy, finance, and geopolitics.

The subject is "as deep as the rabbit hole goes." But there is a possibility for abstraction. Through this process I will try to subset the major determinants of oil prices in four categories. These four categories are technology, economy, fear, and temporal effects. In this article, these relations will be explained and a methodology for understanding world oil price dynamics will be presented. Within this framework, major indicators for price movements will be listed. Financial and economic effects will be further elaborated followed by the geopolitical perspectives and consequences. In the last part, "predictions" for what type of future crises will occur and opportunities stemming from oil price movements and levels will be outlined. In summary, the story and future of the complexity of oil price developments is told through an analytical framework by using the system dynamics approach.

Theoretical and Conceptual Framework

An important aspect of oil prices is the influence of the "paper oil," or the so-called energy futures market. Especially, in explaining the "2008 Oil Bubble" (2008 bubble), one credible theory is the "phenomenal increase in financialization of commodity markets during 2006-2008" (1) However, the discussion has two sides. One group claims that the "oil price peak in 2008 was pure speculation" (2) The other side claims that there is not enough evidence to prove that speculation was the major driver for prices. The explanation for the 2008 bubble is said to rest on fundamentals, meaning oil market fundamentals. Oil market fundamentals, at the time, indicated a growing demand from China and emerging economies, a decrease in producer countries, and no new resources or technology on the horizon.

During that time one popular stream of semi-ideological theory was the "Peak Oil Theory" "Peak Oil" is a theory based on M. King Hubbert's idea that there is a point in time when the maximum rate of extraction of petroleum is reached, after which the rate of production is expected to enter terminal decline. The proof is illustrated in his paper "Nuclear Energy and Fossil Fuels" where Hubbert correctly predicted the decline of U.S. crude oil production. (3) Peak oil advocates assume the world oil reserves, as a stock or a tank. In the first 50 percent of this stock, production will be mostly from "low hanging fruits" But as stock nears 50 percent, production will be harder and more expensive. Hence, as the level of tank drops below 50 percent of its full capacity the oil production will start to drop dramatically. The theory does not consider improvements in technology or new kinds of resources. The reasons why Peak Oil Theory is important is that it triggered the fear that world oil production cannot cope with the growing demand, especially from China during 2000-2008. This fear may have helped both speculators and green movements. The arguments associated with Peak Oil Theory are generally fundamentals (supply, demand, geology etc.), but not all members of the "Fundamental Camp" associate themselves with Peak Oil Theory advocates. According to the Saudis, this "fear factor" has played into the hands of speculators.

WikiLeaks cables show that during the most heated times of the 2008 bubble, May 2008, U.S. officials asked the Saudis to increase production. According to documents, Prince Abdulaziz bin Salman bin Abdulaziz al-Saud said, "[Saudi] Aramco is trying to sell more, but frankly there are no buyers... We are discounting buyers." (4) During the meetings "Saudi officials explained that they have two primary concerns about artificially high crude prices: that they'll dampen the long-term demand for oil and the wide price swings typical of commodity speculation make it difficult for them to plan future oil field development."

However, the naysayers of the discussion claim that the analytical evidence is not obvious. Research based on a comprehensive dataset of individual positions in the most liquid U.S. futures markets for energy and equities (S&P 500 e-Mini), which is maintained by the U.S. Commodity Futures Trading Commission (CFTC), argues that "it is not simply changes in overall energy speculation that help forecast the observed correlations." (5) The real link that looks like a correlation between speculation and oil prices are most likely hedge funds. And according to the article, hedge funds lose their "informativeness" during the periods of elevated financial market stress. One fundamental argument is the relation between the spare capacity and spot price. It is expected that as the market has more spare capacity, spot prices should be less volatile, but when the spare capacity hovers around the margins the prices skyrocket.

One has to understand that if there is no new capacity entering into the market, the production costs would only shoot up to the marginal barrel that is produced. The question is how the price reached 140 dollars when the marginal cost of a barrel was around 70 dollars, according to International Energy Agencies World Energy Outlook reports for the years 2005, 2006, and 2007. One reason, according to a report by the Baker Institute for Public Policy, is the Commodities Futures Modernization Act of 2000 by the Clinton Administration, which "effectively cleared the way for more lax regulation of new oil risk management products" (6) that feed the fire of speculation. The real divergence between the two camps is not the "Fundamentals." They all agree that fundamentals have a part in the 2008 bubble. But the main divergence is whether it is a "causation or correlation."

Fast forwarding to the recent oil price crash, John Kemp from Reuters claims and provides evidence about the relationship between hedge funds' positions and oil prices. His "Fundamentals" are U.S. crude stocks and a number of rigs. Long (the holder of the position will profit if the price of the security goes up) to short positions (the holder of the position will profit if the price of the security goes down) have reached their lowest level in four and a half years. (7) That is to say that most of the money managers bet their money on decreasing oil prices. In the literature one can find both views supporting each side of the discussion. Is it the hedge funds that cause speculation, or pricing of "Fundamentals" by these funds? Nevertheless, a pragmatic view-point would be to watch net long and short positions in the paper markets to improve the forecasting of the trends in oil prices.

Geopolitics

One fear element in oil prices is geopolitics. Whether it is an attack or possibility of an attack to the infrastructure or an improving relationship between Iran and the west or sanctions, the pricing of such events is complex. The effect, the duration, the proximity of tensions to the major oil fields and refineries as well as the share of mentioned countries in the world oil exports are important parameters to consider.

The price movements between July 2014 and January 2015 reflect these trends. Examining this period, the prices are a consequence of the "potential disruption" in Russian oil/gas exports due to sanctions but no major disruptions actually occurred. Still there remains the risk of potential technical equipment shortages for Russian firms, which could impact Russian oil production. Just before the drop of oil prices, Iraqi oil production was disrupted and was priced as a level shifter. However, the prospect of improving conditions in Iraq and Libya to increase oil production initiated the downward slide in oil prices. Global economic prospects, U.S. production, and OPEC's failed attempts to control oil prices accelerated the slide.

As described at the outset of this article, oil prices are priced by factors and temporal perceptions. Oil prices fluctuate with "potential" events but also these same events can impact future prices. In the world of oil market pricing, the reality of today's well or refinery current production could be affected by future outcomes. Tomorrow's probabilities define the present in this volatile industry. A recent example is the U.S.-Iran Nuclear Deal. Although the sanctions will not be lifted before January 2016, oil prices dropped on the day the agreement was reached.

Attacks on oil refinery or pipeline infrastructure are another geopolitical factor often causing oil prices to jump. Generally, they are not perceived as a "big" surprise by markets but their impacts are immediately visible. However there are outliers. There are other events that slowly unfold with unexpected developments, such as the Nigerian elections and the tensions it created within that country. One such event is the explosion on the Turkish part of BTC pipeline before the 2008 Georgian-Russian war. There is plenty of speculation related to this explosion, particularly, because there may have been a cyber attack component. Bloomberg claims, "hackers had shut down alarms, cut off communications and super-pressurized the crude oil in the line, according to four people familiar with the incident... The main weapon at valve station 30 on Aug 5, 2008 was a keyboard." (8) If true, such an attack incorporates multiple dimensions and several geopolitical...