Crude oil as an indicator of global economy

Everyone knows that nowadays the global economy largely depends on crude oil prices. In recent years, analysts and economists have been closely watching US dollar movements against other major currencies as well as oil price dynamics on the global commodity market.

Why are crude prices so important?

Crude oil prices reflect dynamics of the energy sources price in general because oil is the main source of energy on the planet. In other words, infrastructure, production and transportation of food and non-food items, the modern pace of life and standards of living for most people are built on production, transportation, refinery, and the ultimate price of crude oil.

Today, black gold is the main indicator of the global supply and demand balance. Crude oil transactions account for 10% of trade turnover in the world.

Low crude oil prices present challenges for many countries in the world. Cheap oil leads to losses of income and intensifies poverty, which is particularly true for Russia, Brazil, Mexico, and Canada. In oil-dependent economies, low prices result in a weaker national currency, rampant inflation, increased debt burden, wider budget and trade deficit, expensive essential goods, and make vital services less affordable. All of this can destroy fragile governments and disrupt economies that look strong.

Main oil market participants

Major world oil reserves are primarily located in the Middle East in the Persian Gulf basin, as well as in Venezuela and Canada. Among the developed countries, the largest oil deposits are in Canada, the United States, and Russia. The Middle East has the richest conventional light crude oil reserves with Saudi Arabia in the lead. According to the latest data, Saudi Arabia has around 35 billion tons of crude oil; Iran and Iraq possess about 20-22 billion tons, while Russia´s reserves are estimated at 10-15 billion tons.

At present, crude oil is priced in the US dollars on the global energy commodity market. That is why Russia´s budget, for example, depends on both oil prices and the exchange rate of the US dollar to the Russian ruble.

Russia´s influence on oil prices is limited as the Organization of the Petroleum Exporting Countries (OPEC) sets trends in the crude oil market. OPEC is an international cartel established by oil producing countries in order to stabilize prices for the commodity. OPEC has a total of 13 members, including Iraq, Iran, Kuwait, Saudi Arabia, Indonesia, Venezuela, Qatar, Libya, the United Arab Emirates (UAE), Algeria, Nigeria, Ecuador, and Angola. OPEC invited Russia to join the organization but the country remains just an observer.

According to current estimates, OPEC member countries account for almost 81% of the world´s proven oil reserves. Meanwhile, around 66% of the OPEC total reserves are located in the Middle East. OPEC´s proven oil reserves currently stand at 1,206 billion barrels.

As of April 2016, OPEC countries in total ramped up production to 33.217 million barrels per day.

In January 2016, Iran returned to the global crude oil market. The country has the fourth largest oil reserves in the world.

Oil pricing

The price of one barrel of oil is the final price of pumped oil which was processed and became a financial instrument displayed on the trader´s monitor. Today, there are over hundred grades of oil which are determined by oil gravity, sulphur content, and other no less important parameters.

However, on the global crude oil market there are only several most traded grades. They are West Texas Intermediate (WTI), a benchmark for the US market, Brent crude oil, which is used in Europe and OPEC countries, heavy Urals oil and Siberian Light oil traded in Russia, and Norwegian Statfjord oil. Besides, there are African crude oil grades that do not have a benchmark and are usually classified as Brent blend.

A simple formula of oil pricing includes drilling cost, processing cost, transportation costs, as well as the broker´s commission which includes revenue of oil producing companies, taxes, intermediary and stock speculators fees.

The broker´s commission is the less predictable part is because of high geopolitical risks. For example, it is very difficult to forecast the future of Nigeria, Somali, Libya, Russia, and Syria while the global economy is destabilized by the European debt crisis, increasing budget deficit of the United States and Japan, and threatening overheating of the Chinese economy which intensify oil price swings. Political and economic risks of a particular country add to global economic uncertainty and have a huge impact on the crude oil market.

At the same time, crude oil can be refined into more useful products. The refinery process is very costly. Capital costs of an oil refinery are equal to those of a nuclear power plant. As a result, many developing countries rich in crude oil do not have enough money to build a refinery and deliver end products to consumers without foreign investment.

Therefore, the actual market price of oil depends on the following factors:

• production and transportation cost;
• quality of oil;
• change in demand;
• production capacity and productivity levels;
• geopolitical tensions;
• speculations on the stock exchange.

Besides, there is the OPEC Reference Basket, which is a weighted average of actual prices for 13 oil blends: Arab Light (Saudi Arabia), Basra Light (Iraq), Bonny Light (Nigeria), Es Sider (Libya), Girassol (Angola), Iran Heavy (Iran), Kuwait Export (Kuwait), Merey (Venezuela), Murban (UAE), Oriente (Ecuador), Qatar Marine (Qatar), Saharan Blend (Algeria), Minas (Indonesia).

Major oil futures exchanges

In the case of crude oil, the major futures exchanges are the New York Mercantile Exchange (NYMEX) and the Intercontinental Exchange (ICE) based in London. Energy futures, electricity, metals, and futures on stock indices are traded on these exchanges. Trading is conducted in two methods; an open outcry format and electronically.

In addition, investors widely use E-mini futures contracts, which are just 50% of the size of a standard futures contract. They are traded on the CME´s Globex electronic trading platform.

Today, NYMEX is called home of energy futures. Crude oil is traded here with a turnover of $350 million daily.

Why do oil prices fall?

Oil prices have been falling since September 2014.

If we take a look on the history of the crude oil industry, we will see that always there were some reasons for oil price fluctuations. Otherwise, they were artificially created.

The average price of crude oil was drastically falling during the Persian Gulf War, the Islamic revolution in Iran, the Iran-Iraq War, the Asian financial crisis, after the September 11 attacks in 2001, throughout the Iraq War and the global financial crisis.

The price fall in September 2014 is not the first instance for the past 30 years. Moreover, it was not the biggest decline in history, as prices dropped down by 4.5% at that time while they plunged by near 11.5% in September 1988.

Today, even despite slight production cuts, the global market is supplied with around one million barrels of oil in excess of demand. This negatively affects the commodity price.

The market participants are worried about Iran´s return to the global oil market as much as the falling oil demand from China, which is the second-largest consumer of oil. In 2015, China´s oil demand rose by 510,000 barrels per day. Meanwhile, it is expected to grow by mere 300,000 barrels per day in 2016.

Experts say that after anti-Iranian sanctions were lifted, existing oversupply and economic slowdown in China affect significantly the supply and demand balance.

In mid-January 2016, hedge funds increased the number of their short positions in crude oil to the record level over the last 10 years as they expect oil prices to dip lower.

Some analysts say that the global oil market can stabilize by mid-2017. Prices of $40-50 per barrel can help restore the supply and demand balance.

Crude oil prices have been declining at a record pace for the recent 1.5 years. In January 2016, oil prices experienced the biggest weekly decline by more than 11%.