Volatility and the impact of oil prices

Butterfield Market Watch

Eamon F. Cargo

Due to the severe economic recession, by December of 2008 the price of oil had toppled to $35 a barrel from the height of around $140 a barrel in July 2008. In a little more than half a year, there was a 75 per cent decline in the price per barrel. From the lows of 2009, the price per barrel has skyrocketed back up roughly 200 per cent to a range of $70-110 a barrel for much of 2010 and first four months of 2011.

Why are oil prices so volatile?

There are numerous variables that cause increases and decreases in oil prices. Changes in oil prices, as with most commodities, are based on supply and demand forces.

Changes in supply

The supply of oil is largely managed by Organisation of the Petroleum Exporting Countries cartel. Up until the middle of the 1980s, OPEC set the price of crude oil. It still influences the market by adjusting production levels for its members. OPEC members supply nearly 40 per cent of the global oil supply.

There are other factors that can greatly influence supply. In early 2011, there were supply issues and concerns. This was attributed to anticipated or realised supply side disruptions due to the uprisings in Egypt and Libya as well as other counties in the Middle East.

Changes in demand

There are many factors that can influence the amount of demand for oil. For example, in late 2008 there was an abundance of supply but there was dwindling demand due to the slowing of the global economy which led to a precipitous drop in oil prices.

In 2010, as the global economy was recovering from a severe economic recession emerging economies were ramping up activities. This increase in economic activity, in turn, created increased demand for oil.

Another factor that affects demand for oil and has gained media attention over the past few years is increased speculative behaviour by investors outside the oil industry. This has added to the volatility of oil prices. Investors such as hedge funds, pension funds and investment banks will hold and trade sizeable positions in commodities such as oil. They usually establish positions for two reasons. One is the added diversification to the portfolio, the other reason is to try to profit from price swings.

Oil prices and industry impact

The impact of high oil prices can be vast. High oil prices make some companies much more profitable and other companies far less profitable at the same time. Two industries that are very oil price sensitive are oil drillers and trucking companies. They are on opposite sides of the spectrum in regards to their exposure to oil prices and how it impacts their income statement.

For drilling companies, there is a large fixed expense in surveying land to determine if there is potential for oil deposits. The drilling company first has to determine if there is a high probability of oil and then it will drill to determine if there is indeed oil in the ground. The search for oil often turns out to be unproductive, but the practice is vital in locating new sources of oil. Depending on the price of oil, it can be less or more advantageous to even engage in oil exploration. With oil prices below $40 a barrel, many drilling companies will halt new oil exploration projects until the price increases.

On the other side of the coin, transportation companies such as trucking companies use a large amount of oil in the form of gas to deliver goods. As oil prices increase, trucking companies will usually absorb part of the cost so as not to pass along the cost to their customers. However, if prices increase drastically and for a persistent amount of time, they will most likely have to pass along those extra costs to customers to remain in business. This, in turn, will cause their customers to use alternative methods of transportation for longer distances such as the railroad or cause them to absorb part of the increased cost and possibly pass it along to their customers.

Will the oil prices be 
as volatile in the future?

Changes in the dynamics of supply and demand are likely to continue a history of oil price volatility. One of the structural reasons is the sustained increase in demand. It is projected by many economists that global demand for commodities will grow at a double-digit rate over the next decade because of two key factors: population growth and economic development.

As for supply, a major issue is that most of the easy places to explore for oil have already been fully developed. This leaves more remote areas for exploration, which will be more costly to abstract.

Two mitigating factors are that alternative energy in the form of renewable energy sources and advances in technology could alleviate some of the future demand for oil albeit by how much raises another question.

In summary we should expect a continued high level of volatility in oil prices for the foreseeable future.