Oil and Gas Prices

The oil price is obviously one of the key ingredients of an economic evaluation for an oil prospect. For gas, the oil price is also quite important in many situations, as the gas prices (piped and LNG) may be coupled to the oil price in some complicated way. Probably most economic/political studies have centered on the oil price. The variation is staggering: from one or two dollars/barrel in the 1960ies to a peak of almost $ 150/barrel in July 2008. Other significant, and politically induced peaks were in 1973 and 1979. In the last few years the effect of a rapid increase of non-conventional oil in the USA and Canada has caused an oversupply in the light of the sluggish demand due to the crisis. This has suppressed oil price to the 40 to 60$/barrel for Brent and affected the gas prices. The potential of the non-conventionals has been reviewed by Sandrea (2012).

Oil comes in different qualities. There are price standards such as crude oil price linked to Japan Customs-cleared Crude or JCC, the price of Brent crude and or the West Texas Intermediate ("WTI"). The distance between the production and the main market also plays a role. In the short term, buffers, such as the strategic petroleum reserves, storage and the amount of crude and products moving over the seas are reducing the risk of sudden shortages, but can have significant effects on the oil price. In 2017 the total of this buffer could be in the order of 8 billion barrels! (see the Natural Gas World (NGW) site).

The fundamental play of supply and demand is often spoiled by cartel actions and by wars or other upheavals, in other words: a mainly chaotic system.

(From www.oilism.com)

It could be argued that the oil price is established in the oil spot market by the interaction of supply and demand. On the other hand, the cartel mechanism and actions by governments in both producing and consuming nations will influence the level at which the oil price is fluctuating. A selection of factors will either pull the price up or suppress it:

Higher oil priceLower oil price
Depleting resource baseEconomic downturn - less demand
Low OPEC quotaCheating on quotas by poorer OPEC members
Nationalization in
producing countries
Increased fuel taxation
in consumer countries
Increased taxation of
oil companies in producing countries
Market gains over oil by
natural gas in home heating and power generation
Revolution and war,
disrupting oil supply
Environmental concerns about
global warming
A long cold winterA mild winter

Because of the interaction of these factors, their random arrival times and different lag times before taking effect, we obtain a quasi-chaotic price system. The past performance suggests that the left positive factors (table above) have the upper hand during certain periods, the negative factors otherwise. In chaos theory terminology: there are two "strange attractors". Within such an attractor the market is reasonably stable. However can not predict how long such a condition may last. Possibly a relevant illustration may be the butterfly diagram of E.N.Lorentz (1963). This diagram shows how a process may wander from condition to condition but with quasi-stationnarity for unpredictable periods. The picture is based on a simple model in which three non-linear equations interact. The lower part (in blue) shows the two alternative conditions labeled "position", while the upper part (in red) is a record in time of where the process was situated and for how long. The left attractor might be a "stable" low price, the right one the high price.

Oil and gas prices are to a certain extent interlinked. In some contracts, the gas price is a function of the price of a basket of oil products in the period six months before. But in general there is a positive, but rough correlation as studied in depth by Villar et al. in 2006. Because most gas is either used locally in the country of production, or transported by pipeline to a consumer country, there is less flexibility for a gas spot market. However the increase in market share of liquified natural gas (LNG) has made the gas markets much more flexible. However, the major part of the traded LNG is ound by long term contracts. So the LNG trade is still far from commodity trading and an LNG spot market setting the price.

I have studied one of the positive feedback mechanisms linking oil price to global production levels. There is a significant correlation, although far from stable in time. The response of production has a short term effect, if there is surplus production capacity ("opening the taps"). However, in the longer term, the need for expanding production in new fields, by drilling and building facilities causes a time lag of several years for the long term response to oil price. With their very large production capacity Saoudi Arabia has been and probably will be in the position of "swing producer" within the constraints that OPEC poses.

For analysis of, and information on the history of oil prices I recommend WTRG Economics.