Prospecting the academic grounds on global energies patterns
How does the market for energy commodities work?
The Fundamentals of a market are the forces determining the supply and demand. As an example, the seasonal temperature is a fundamental for the demand side; on the supply side the respect for quotas in the OPEC cartel, or the stocks level of fuels in California are determinant. Those are considered by the analysts of the market to explain the movement in equilibrium of the quantities and prices, and predict their evolutions. This equilibrium reflects an “objective” price.
Clearly, for the energy commodities there is not direct agreement between a producer and a consumer; but a long chain of intermediaries.
For oil, the price is set on the spot market; the price of other transactions being usually fixed in reference to this price.
Obviously, the price of energy lies between two bounds: the upper bound being the price of the alternative energy and the lower bound the marginal cost of the least successful producer.
Flexibility for the upper bound: In the residential sector, oil, gas and electricity are direct competitors but in the short term consumers cannot switch from one to another. In the industrial sector, some companies will be equipped for both oil and gas such that they can switch to the cheapest source of energy when necessary; but this only concerns the biggest companies.
If the gas price is upper-bounded by the oil price, the price of oil has no competitor for its transport use and has no theoretical upper-bound.
For the lower bound, JP Favennec distinguishes between short term and long term marginal cost. The short reflects when the least successful producer stops, this price doesn’t remunerate the initial investment. The long is the one where the least successful producer cover its proportional costs. Its the minimum price to obtain the renewal of the capital necessary for the extraction/transportation/refining processes. As opposed to a traditional industrial analysis, the industrial equipment once amortized can still conserve a production capacity; it is not the case for oil and gas field. The capital invested to extract oil/gas is lost once the oil/gas field is empty.
Further, Favennec describes a cycle on the supply side. If the market price reaches the short term price, the investment to renew the capital doesn’t occur. The supply slowly decreases as current oil fields get depleted and the price goes up again. On the reverse, if the price is high for a long period of time, allowing for further investment and building of larger production capacities leading after a few years to over-supply; thus the price decreases to reach the short term marginal cost. (…)
As an example, during the late 90s, when the price of oil reached an historical minimum level, it was observed that the short term marginal price was around 10$/barrel for the majors.
If gas can also been transported, it needs higher investments. Natural-gas line or liquefaction refinery chains are long and very expensive to build.
The amortization for this type of transportation capital is far higher than the cost of extraction. While those costs don’t appear when considering alternative energies (solar/ wind/ biomass), it is still a challenge to explain why their productions have not been increasing further since their earlier development in the 70s.
Since 86, OPEC renounces to impose long term contracts at fixed prices, 80% of crude oil since traded in the world is then determined as function of the spot markets price. The influence of these markets was also extended to all primary fuels: In Europe:
-The long-term contracts for natural gas depended on the price of diesel/fuel
-The LNG also depend on the prices of crude oil.
In the US, the arbitrage of consumers infer a strong correlation between those energies prices as well.
Despite its influence on prices determinants in the world, the spot market represents only 30% of transactions in the world- More than half of the transactions are negotiated in the form of long-term contracts (futures-which emerged in the 80s – last for a period of one year and are renewable) in London, NY (NYMEX) and Tokyo.
We usually observe three types of contracts:
-Forward: non-organized market: planned delivery.
– OTC (de gré à gré) : over the counter (conditions defined on custom)
– Barter: weapons against oil / industrial equipment
futures market: contracts that give rise to physical delivery or not
derivatives market (swaps / options): (from 1992) hedge funds increased in international markets is accompanied by increasing volatility of oil prices (Check!)
These funds also are interested in refined products-rather than speculating against the fundamentals of physical markets, they anticipate turning points of trends (Maurice 2001: 35): this could be a cause of the sharp rise in prices oil occurred in 2007.
How do the oil prices interact with the real economy?
Some observe that the growth rate of GDP is a predictor of the long term changes in oil demand, it should thus indirectly relate to price of oil on the international markets. One could say that the international market of hydrocarbons is demand driven (except in the 70s). The cyclicality of oil price is one of the key aspect we will address further. If one could certainly imagine that strong economic strong implies more intensive energy use, the crisis occurring (oil shocks) in the 70s have driven economics to consider the effects of an oil price increase when we are on the equilibrium growth path. Those effects are further explain on this page. One of the main concerns to assess the effects of oil price changes acting on an equilibrium growth path would depend on the elasticity of production to energy (when energy is considered as an input) For example, intensive use of petroleum products in some industries and transport industries would result in a very low elasticity of demand to price due to low substitution of oil by other sources. Some will remark that this low elasticity of demand to price contrasts with the higher elasticity with respect to revenues as a general decrease of oil price follows a recession.
The financiarization of the oil and gas market will be addressed on this page.