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The Importance Of Oil Price In Market Economy

Oil price has become a fundamental factor of today’s market economy as it influences financial markets as well as consumers, corporations and governments. Oil fluctuation has not only a tremendous impact over the stock markets but also a major influence on the global economy: oil is needed for industrial purpose such as power generation, chemical products, transportation etc. In particular oil demand and supply drive volatility and any upward or downward price movements is tracked by any financial market player as it directly influences future outlook and real growth of exporting and importing countries. Higher crude oil price implies higher price of energy leading to a slower economic growth, inflationary pressure, asymmetrical results on consumers and producers side and global imbalances. Oil scarcity and increasing demand of emerging market countries have changed oil market as well as political uncertainty leads to an increase in oil volatility.
Since 2000, crude oil has experienced an incredible price rally, moving from $25 in 2000 to over $144 in July 2008 and getting back later December 2008 to $35. These huge price changes are mainly undesired because they increase uncertainty and undermine investment in oil as well as alternative energy sources. Even if we are getting more and more familiar with this price uncertainty or at least with oil price volatility, it is necessary to understand the key driver of this commodity in order to be able to conduct accurate studies and to forecast and prevent new worldwide market chock: there are mainly two different explanation to oil price behavior. The first one is related to the idea that markets are experiencing a structural transformation in oil price fundamentals; the second one is related to substantial speculation in oil market. The supporters of this second view argue that the massive oil crude price cannot be explained by simple change in market fundamentals but can be rather explained through a market distortion caused by speculators.
This dissertation will investigate oil and the oil market players trying to understand the different price determinants and the interaction of key players: it starts with an historical overview of oil price and it successively analyzed oil as a commodity, oil as a financial asset, the role of expectations in the formation of oil price, the industry outlook for the next years, oil derivatives on the financial markets.
Oil Fundamentals History Oil industry was born in the 1859 in Pennsylvania, United States when Edwin Drake opened the first oil well. The industry grew slowly during the second half of 1800 when the business pioneer George Bissell together with the banker, James Townsend, established the first oil company: Pennsylvania Rock Oil Company. The industry became more and more attractive and in 1870 John D. Rockefeller established the Standard Oil Company. Boosted by the introduction of the internal combustion engine and by an increasing energy demand caused by the outbreak of World War I, the oil industry became one of the foundations of modern industrial society, ready to overcome coal as the most used and requested energy source.
As the graph points out the price of oil remained steady from the beginning of the century until the first energy crisis, risen by less than two percent per year. Spot crude oil price moved from $2.83 per barrel of 1973 to $10.41 of 1974. This increase in price was caused by the oil embargo proclaimed by the OPEC, Organization of Arab Petroleum Exporting countries in response to the U.S. decision to re-supply the Israeli military during the 1973 Arab-Israeli War, fought between Israel and a coalition of Arab states backing Egypt and Syria. The OPEC countries limited their production as well as the shipment of oil cargos to United States and other countries. The embargo led to quadrupled and extremely volatile oil price and it showed how high was the dependency of western economies from the oil reserves controlled by the OPEC members. Following the first oil crisis, in 1979 took place another sharp rise of oil prices following the Iranian revolution: the overthrow of the regime of Shah Reza Pahlavi triggered a strong speculative movements of oil price. The price increased from the $14 needed to buy a barrel in 1978 to roughly $30 in 1979 causing a widespread panic and affecting geopolitical forces. Moreover in 1980, Iraqi invaded Iran leading to oil cut production of Iraq and a total stop of Iranian production. All these events strongly influenced oil price and demonstrated how pure supply and demand get overcome from sociopolitical facts.
The so-called oil glut of 80s changed again the oil market environment as the price of the black gold fell from $35 to $15 in 1986 due to a falling demand, slowed economic activities in industrial countries and an increase in production. The crude oil price fluctuated between $15 and $25 until 1999. At the beginning of the new century the oil price increased exponentially and reaching $30 in 2003, it moved to $60 dollar in 2005 and peaked at $148 in 2008. This incredible ride of oil can be explained by different factor such as decreasing US Dollar value against other currencies, declining petroleum reserves, speculation, increasing demand from emerging market and OPEC’s lower than expected increase in production. But after reaching the peak on July, 11th 2008 the price declined consistently falling below $100 on September 2008. Because of the financial crisis world oil demand fell rapidly and in just a couple of months it touched the lowest point at $34. Until April 2009 oil price fluctuated between $35 and $40 and “recovered” to roughly $70 in early 2010.
Oil as a product People are more familiar with refined oil products such as gasoline, diesel, kerosene and heating oil rather than with crude oil. The basic oil refining process is distillation: “crude oil is heated and oil products bubble off at different temperatures, the lightest at the lowest temperatures and the heaviest at the highest temperatures” [1] . Afterward these products are treated further to make finished oil products such as gasoline kerosene etc. Gasoline is commonly used for cars while kerosene is widely developed for airplanes and household’s illumination heating. Diesel is widespread as combustible for tracks and agricultural machines while heating oil is mainly used for space heating. Oil this different refined products come from crude oil and even if crude oil is considered as a commodity, there are several qualities of crude depending mainly on two different chemical properties: density and sulphur content. Crude oil is therefore divided into heavy or light according to the density level and sweet or sour according to the sulphur content. Nonetheless, in financial market, the three most quoted products are:
West Texas Intermediate Crude, WTI – very high-quality, sweet, light crude widely traded in Nord-America
Brent Crude – a basket of 15 similar middle-high quality, light, sweet crude oils extracted in the North Sea
Dubai Crude – light sour crude oil extracted in Dubai
Even though West Texas Intermediate Crude has the highest quality, Brent is used to price two thirds of the world’s internationally traded crude oil supplies according to the International Petroleum Exchange (IPE).
Oil characteristics: Exhaustibility One of the leading feature of oil is that oil is a non-renewable resource as once it is consumed, it is no longer available. In particular once extracted, oil is consumed quicker that it is naturally produced: oil is therefore not replaceable within short time. Another very important feature is that supply of such as product is limited relative to demand.
This two characteristics are essential to understand that oil can only be analyzed through dynamics models and that unlike standards goods, oil provides oil holder a positive premium known as scarcity rent. When demand for crude oil exceeds supply, oil price earns an economic rent due to its scarcity: in other words, it worth keeping oil underground waiting for increase in demand not covered by an increase in supply.
The framework which is widely widespread regarding non-renewable resources is the Hotelling model: first introduces in 1931, the model questioned which is the amount of resources that should be extracted during a certain time frame in order to maximize the profit of the resource holder? Assuming no extraction costs, a risk free rate on investment equal to r and a certain price per barrel, according to Hotelling model, the optimum extraction quantity is the one that leads the price of oil to grow over time at a interest rate r. In other words, the resource holder has two opportunities: he can extract oil today or he can leave it underground waiting for a rose in price. Assuming that he decides to extract a certain amount today, he can invest the proceeds at a risk free rate r; otherwise, if oil price is expected to grow at a higher rate than r, the resource holder is not incentivized to extract oil. Thus, if all the resource holders behave the same way, it is highly probably that oil price will increase. Therefore, according to Hotelling models, the optimum extraction is the one in which oil price grows at the rate of interest. This model suggests and implies that oil price will increase over time: due to oil’s exhaustibility oil price must increase as fast as it is consumed.
Even though Hotelling’s model is commonly used to predict the shape of oil’s trend, one of the most important Hotelling’s assumption is that the reserves of oil are fixed: as can be understood later on in the dissertation, oil reserves calculation is far from being detailed and exhaustive. Oil is extracted as well as found continuously: new reserves become continuously new available resources. Thus, an argument against the Hotelling’ approach is that it is not possible to evaluate scarcity rent and therefore it is not possible to use models such the Hotelling one which are based on this data.
Demand and supply. As for any product, the main drivers influencing oil price are demand and supply. In the long term oil price is determined by the match of demand and supply; however, due to the peculiarities of oil, it is really difficult to predict future price: unknown future events, wars, natural events, OPEC decisions on cutting production and demand elasticity shape different demand-supply equilibriums. While price and income are demand’s main drivers, on the supply side it is necessary to take into consideration several factor such as reserves, oil depletion, technologies and oil cartel decisions.
Oil Supply In January 2010, global oil supply accounts for 85,8 million barrels per day, out of which 51,6 has been produced by non-OPEC countries.
There are different factors that are needed to take into consideration analyzing crude oil demand. Evaluating the supply is more complicated than evaluating the demand as there are different player involved, OPEC and non-OPEC countries and there is the central issue related to oil reserves level. First of all, exporting countries do not incur in any storage’s cost for crude oil as they can simply decide to leave oil underground while importing countries, in order to establish a minimum reserve level, need to built storage facilities. In regard to production countries, the most important and influential player is the Organization of the Petroleum Exporting Countries. While non-OPEC countries act competitively, OPEC is a cartel whose aim is to maximize revenues and profits.
OPEC The Organization of the Petroleum Exporting Countries (OPEC) is a permanent, intergovernmental organization founded in Baghdad in 1960 and at that time it encompassed 5 countries: Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. The founding members were later joined by nine other members: Qatar (1961- 2009); Indonesia (1962 – 2009); Socialist Peoples Libyan Arab Jamahiriya (1962); United Arab Emirates (1967); Algeria (1969); Nigeria (1971); Ecuador (1973); Angola (2007) and Gabon (1975-1994). Since 1965 OPEC headquarters is Vienna. It is interesting to highlight that the declared mission of the organization is “to coordinate and unify the petroleum policies of member countries and ensure the stabilization of oil markets in order to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers and a fair return on capital to those investing in the petroleum industry” [2] .
In order to understand the relevance of the OPEC countries over oil market, it is important to quantifies to what extend are worldwide oil reserves in OPEC territories: at the end of 2008, world proven crude oil reserves stood at 1,295,085 million barrels, of which 1,027,085 million barrels, or 79.3 per cent, was in OPEC member countries. In 2008 OPEC countries produced around 33 million barrels per day of crude oil, or 45.9 per cent of the world total output [3] . Besides owing the largest oil reserves, OPEC countries have the lowest production costs: roughly $4.00 per barrel for Saudi Arabia or $ 4.50 for Iran, as compared, for example, with $9.85 for the North Sea and $12.50 for Brazil. [4]
Non-OPEC countries Non-OPEC countries are generally considered as price taker and even though in the last decade oil price has grown consistently and observers would expects a proportional increase in non-OPEC supply, the response of oil producers countries outside OPEC has been weak. There are several factors that are needed to taken into account in order to understand this behavior: first of all it is becoming more and more costly to develop oil reserves in this countries and the level of technologies needed to increase or at least maintain stable the production output is really high and expensive. Moreover, price volatility has increased uncertainty, changing the risk profile of non-OPEC countries: they are becoming more sensitive to oil price cycle. Investment are therefore asymmetrical: during tremendous increase in oil price, investment are modest, while during a decrease in crude oil price investment rate in exploration or new technologies decrease consistently leading sometimes to underinvestment periods.
In order to analyze non-OPEC countries oil supply, it is possible to use a model introduce by Marion King Hubbert in 1956. According to Hubbert model, known also as the Hubbert peak theory, oil production tends to follow a bell-shaped curve which can be divided in three different phases:
the first one, the pre-peak phase shows a exponential growth in oil production;
around the peak, the production reaches the maximum production level and the production becomes stagnant;
in the following phase, the last one, oil production starts a terminal decline due to resource depletion.
The peak is reached when half of the oil reserves has been discovered and used: in order to draw the bell-shaped curve, it is necessary to calculate historical cumulative production, discovery rate of new oil deposit and the size of the URR, ultimately recoverable reserves. The main idea of the model is in fact that oil is a finite resources and therefore, when discovery rate is less than the oil consumption rate, oil production starts inexorably to decline with all the related consequences on oil price. The bell curve is drawn considering both the cumulative production and the remaining volume of oil that will be produced as a percentage of the total oil already produced in past. As a consequence it can be used in order to calculate and forecasts oil production and consequently price forecasts.
According to Hubbert, North America reached the peak point in 1960, while in United Kingdom and Norway the maximum has been touched in 1999.
The limits of this approach are related to the difficulties to calculate ultimately recoverable reserves: improvements in technologies and discoveries of new deposits or higher exploitation of existing deposits are pushing the oil peak to the right. Instead of being static, ultimately recoverable reserve is a dynamic measure: underestimation or overestimation of oil reserves as well as higher rate of technological improvements lead to mistakes in calculation of the year in which world will reach the peak oil.
Oil reserves A proper forecast of existing oil reserve is a fundamental aspect of oil supply as it is central to Hubbert peak theory. First of all, it is necessary to define the different type of reserves available:
Proved reserves are crude oil reserves that once calculated, provide at least with a rate of 90% of certainty at least the oil crude amount estimated. This depends on how accurate are the geological researches
Unproven reserves are crude oil reserves similar to proved reserves but for several reasons such as political or contractual are certain for a rate lower of 90%. Therefore unproven reserves are divided into probable reserves which are reserves that are certain for at least 50 % of the amount estimated and possible reserves which are unproven reserves that are certain only for a 10% of the previous amount estimated
Given the different definition of oil reserves, it is very important to highlight that there is not a convergence estimation of oil reserves: several studies calculated different reserves level according to different study methods and according to the extent of proved and unproved oil definition. Another distortion of oil reserve calculation is due to the fact that exporting countries are willing to overestimate their reserves because higher are the reserves, higher is the quantity that they can sell or export. Moreover, higher are the reserves declared, higher are the loan that these countries can raise.
There is another issue related to the difference between conventional oil and unconventional oil. Unconventional oil refers to the oil extracted using other techniques than the common oil well method such as biofuels, oil shale, oil sands etc.
In addition to these, there are reserves of oil that are yet to be discovered but given the current level of technologies are too difficult to be reached and explored.
It is therefore clear that oil reserve calculation is really complicated: according to OPEC annual statistical bulletin 2008, world proven crude oil reserve are estimated to be 1,3 trillion barrels out of which 79, 3% are maintained under OPEC countries’ ground [5] . According to the Oil

Poverty Ethiopia Growth

Ethiopia has poor infrastructure, persistent food insecurity, and tough government bureaucracy, one of Africa’s worst AIDS epidemics, no stock market, а weak entrepreneurial tradition, poor internet connections and uneasy labor relations. And it lives in а tough neighborhood alongside countries such as war-torn Sudan, Somalia and Kenya. In the global race for investment dollars, conventional wisdom might place poverty-stricken Ethiopia among the world’s bleakest prospects. Its comparative advantage is poverty and cheap labor.
Ethiopia is а developing country. The level of growth is very poor and а slow, and isn’t improving nowadays. This poor country continues to face complex economic problems as one of the poorest and least developed countries in Africa. Its Economy is based chiefly on agriculture and weather plays а major factor in success rates. The growth is not so much attractive and doesn’t look very hopeful. Modern industry bears from under investment, shortages of raw material and poor management. Standard of Living: The GNP of Ethiopia is 113 per capita, being extremely low, and intolerable for any form of adequate survival. (Roberts, 2000) The level of living in turn is substantially low. Major cities tend to be slightly better than other areas, but not by much.
The primary Industry of Ethiopia is Agriculture, employing roughly 85% of the country’s workers. The rest of the working population is broken down to 10% in service industries, and the final 5% in manufacturing. There are approximately 9 main natural resources and 1 raw material found in abundance in Ethiopia. Two fourth of the power is supplied through hydroelectricity, making Ethiopia one of а modern and least dependent on outside sources of energy in Africa. Country has а also narrow-gauge railways, seaports, and National highways that connect а major population hub in the central plateau and Eritrea. This is only а small portion of Ethiopia’s transportation systems. Many parts of this poor country are made up of unpaved or uncrossable tracks, making transportation slow and useless. The ratio of people to automobiles is 810:1. The labor involved is monotonous and backbreaking. Workers are being paid low for their work, and are typically situated in inadequate working facilities. Purchasing markets are few and not good enough to buy cloth etc. Ethiopia’s capital is very low, and they do receive foreign aid and tariffs.
Poverty and Domestic Issues
Ethiopia’s chronic poverty is largely due to high population growth and poor economic performance, exacerbated by mismanagement, conflict and drought. During 1981-91, population grew at nearly 3 per cent per year as compared to economic growth of 1.7 per cent and increase in agricultural production of 0.9 per cent. Between 1978/9 and 1988/9, per-capita food grain production dropped from 200kg to about 150kg, while food imports increased from 178,200 tons to 1,460,400 tons, with relief aid amounting to 70 per cent of the total (ESRDF, 1995: 3). The causes included policy distortions; state grain monopolies and constraints on internal trade; land degradation; low use of agricultural technology; and recurrent drought.
Domestic conflict and insecurity played а key role, both directly and indirectly. The state’s huge military expenditure and lack of development assistance constrained development of water resources for irrigation and power essential components of increased food security and poverty reduction in the Ethiopian situation.
The Effects Of Complex Economic Emergency And Interventions
А major cost of conflict and economic mismanagement under the Derg regime, was the exacerbation of chronic poverty and problems of drought and famine. By 1984, Tigray region was roughly divided into two parts: towns and surrounding areas remained under government control, while rural areas were largely under the TPLF (Hendrie, 1994: 127). In rural areas people lived strong-minded with new hopes. Residents of government-held towns depended on food brought in by truck convoys from the south. People in TPLF areas lost access to towns with grain markets а disaster for poor households dependent on these markets for access to food.
The central government’s counter-insurgency strategy directly targeting the civilian population was, with drought, а major ca-use of the chronic humanitarian crisis of the mid-1980s (Hendrie, 1999: 65). One aspect of this was the launching of ground offensives against those parts of western Tigray still producing а grain surplus (ibid.). The offensives targeted civilian economies and coping mechanisms and aimed to destroy the support base of opposition movements. The consequences were famine and asset depletion, making rehabilitation difficult and leading to chronic and recurrent emergency.
Economy And Development
Following 17 years of the Derg dictatorship and devastating wars, Ethiopia’s society and economy was in ruins. More than 400,000 demobilized soldiers and their families were largely destitute, as were up to one million people displaced in ethnic conflicts that flared up after the fall of the Derg. There were thousands of Ethiopians, including long-term residents, evicted from Eritrea; hundreds of thousands returning from exile in neighboring countries; and thousands forced by new conflicts to flee areas where they had been resettled.
In May 1991, the Transitional Government of Ethiopia (TGE) inherited а ruined economy and massive debts from 17 years of Derg misrule. An early action of the new regime was to issue а charter for the transitional period, indicating the new political direction, with the ‘national question’ at the centre of the impending political transformation. In November 1991, it followed up with а policy paper outlining the economic policy of the transitional period and major principles of moving towards а market economy, creating an environment conducive to investment, and rehabilitating the war-torn economy.
With donor assistance, the TGE set up an Emergency Recovery and Reconstruction Program (ERRP) for economic revival together with а macroeconomic reform program. This helped to stabilize the economy by dismantling the military regime’s centrally planned economic system, restoring Ethiopia’s competitive position through exchange-rate devaluation, and opening up opportunities for private investment, leading to renewed growth in the industrial and service sectors.
This was the prelude to а substantial structural adjustment program (SAP) and а comprehensive policy framework (1992) outlining major reforms agreed between the TGE, the World Bank and International Monetary Fund (IMF). This led to а reform package with three overlapping phases: stabilization, structural reform and further structural reform, with the first phase focused on tighter fiscal and monetary policies and adjusting exchange rates.
The social impact of the SAP was reflected in its effect on incomes, prices, the availability of essential services and high urban unemployment. Reduced extraction of resources from the rural sector meant less to support the centre, particularly the major urban sector of government employment, which was drastically reduced by the SAP. The Ethiopian Social Rehabilitation Fund (ESRF), later called the Ethiopian Social Rehabilitation and Development Fund (ESRDF), was established in June 1992 to help address these problems. It has since played а significant role in rehabilitating basic services, supporting income generation and reducing poverty for the poorest sectors of society.
The government’s development strategy aims to reduce poverty through а combination of sustained economic growth, improved basic social services and targeted measures to improve incomes, self-reliance and quality of life for the poorest groups and communities. Increased participation of primary stakeholders is seen as essential to all these areas (ESRDF, 1995: 4). It also emphasizes women’s participation in development planning and implementation. By 1994 the extent of poverty was reduced to 49 per cent with а 21 per cent consumption gap (Dercon and Krishnan, 1998). А later study by the Addis Ababa and Goteborg universities indicates а marginal decrease of urban poverty between 1994-7 from 41 to 39 per cent (Tafesse, 2000). А government poverty report based on 1995/6 household surveys, put the level of poverty at 45 per cent (47 rural households; 33 urban households). There have been decisive moves towards trade liberalization, reducing import duties and privatizing state enterprises. Government policy calls for an increased role for the private sector, although progress has been slow. The principal obstacles continue to include elements of the government bureaucracy, together with the land policy and lack of infrastructure.
From the above discussion it can be concluded that the future of Ethiopia is dark. Due to lack of economic opportunities or no proper planning the economic life is below poverty level. The failure to produce sufficient food for its existed population still builds mass hunger. The rulers of this country do not appear to be thinking any planning of future, making chances of development almost expected.
Dercon and Krishnan (1998) Changes in Rural Poverty in Ethiopia, 1989-95. World Bank Discussion Paper. Cited in G. Tafesse (ed.) The Dynamics of Poverty in Ethiopia. Paper presented at the Symposium for Reviewing Ethiopia’s Socioeconomic Performance 19911999, Addis Ababa, 26-9 April.
ESRDF (1995) Ethiopian Social Rehabilitation and Development Fund project document, 28 December.
Hendrie, B. (1994) Relief Aid Behind the Lines: The Cross-Border Operation in Tigray. In J. Macrae and А. Zwi (eds.) War and Hunger. Zed Books and Save the Children UK, London.
Hendrie, B. (1999) Local Effects of Revolutionary Reform in а Tigray Village, Northern Ethiopia. Ph.D. thesis, University College, London.
Roberts, N. (2000) World Bank Strategy in Ethiopia. Paper presented to the Symposium for Reviewing Ethiopia’s Socioeconomic Performance 1991-1999, 26-9 April, Addis Ababa.
Tafesse, G. (2000) The Dynamics of Poverty in Ethiopia. Paper presented to the Symposium for Reviewing Ethiopia’s Socioeconomic Performance 1991-1999, April 26-9. Addis Ababa.