Explained: Recent oil price volatility

Oil prices have always fluctuated, sometimes totally surprising us. And a combination of factors, both on the supply and demand side, are responsible for it

After hitting a record low against the US dollar, the Indian rupee is now showing signs of firming. The credit for it goes largely to the cooling oil prices. A while back, it was just the opposite: rising oil prices were draining the nation of its foreign reserves leading to the rupee hovering at around 74 a dollar.

Though things maybe looking slightly upbeat now, one still cannot help but wonder what a continued rise to previous levels of $100 to $150 a barrel (seen before 2014) could do to the economy. Being a major oil importer – the nation purchases 80 percent of its oil from other nations – it would probably leave very little for the government’s allocations towards welfare schemes and other expenditures. Worse, it could lead to a spike in direct and indirect taxes being imposed on the people.

For major importers of the commodity such as India, as we see here, higher prices are a bane and lower a boon.

On the other hand, for major exporters, particularly in the absence of solid revenue from other sources, it is lower prices that can prove disastrous. A glaring example of it is Venezuela, whose clout in the Latin American region grew with record high price of oil from 2006 to 2014. Once prices started nosediving, the nation whose mainstay is oil, saw its economy in shambles.

Hence, oil prices, typically characterized by high volatility, can be a make or break for nations.

But what are the factors affecting its movements?

Of course, its demand-supply dynamics at the end of the day. And what are the factors controlling those?

We take a closer look below:

Supply side

Organisation of Petroleum Exporting Countries (OPEC)

Talking of supply, the Organization of the Petroleum Exporting Countries, known popularly as OPEC, deserves a mention at the outset. An intergovernmental organization of 15 nations, founded in 1960 in Baghdad, it is now headquartered in Vienna, Austria.

These nations are prominent oil producers and exporters. Their decision to cut production or supply leads to a global oil price rise, at least in the short term. In the long run, however, they cannot afford to cut back production to prop up prices. It would mean revenue loss and subsequent ceding of market share to rival producers.

In fact, the oil rally till a month back this year – in October first week this year crude oil prices hit four-year highs – was a result of OPEC nations limiting production to drain the glut.

Another reason pushing up prices was the economic crisis in Venezuela and the US sanctions on Iran – major oil producers in OPEC.

To explain a little more, Venezuela’s economic crisis (result of falling oil prices) led to a severe shortage of food, medication and other essential items. This caused hyper-inflation, forcing its citizens to migrate to other nations en masse. This, in turn, led to labour shortage thereby affecting operations of oil fields. Subsequently production got hit. As things stand today, Venezuela’s oil production has fallen to its lowest point in more than 70 years.

Iran, the third largest producer in Middle East dominated producer cartel, has faced US led sanctions on oil, gas, petrochemical and refined petroleum products for long. The reason behind it is the west’s fears that Iran’s uranium enrichment programme is actually a covert operation for producing nuclear weapons. And with the US threatening fresh sanctions, there have been serious concerns about supply.

However, such macros haven’t been able to prevent downward pressure on oil prices again. With other nations still pumping oil at record levels and the OPEC deciding to put more barrels into the market once again, prices have started tumbling. Now the OPEC producers are mulling upon cutting back production and supply.

Oil boom in the US and Canada

Shale gas production in the US on a commercial scale, in the present century, has proved to be a game changer for the oil industry. The US shale boom, made possible by modern drilling technologies such as hydraulic fracturing and horizontal drilling that helped extract oil from shale rock formations, allowed the US counter the negative impact of steep oil prices circa 2003.

Canada also followed suit by cranking up production on its home territory (the nation hosts the world’s third largest crude oil reserves). The local production enabled the North America nations to reduce their oil exports substantially.

That combined with Saudi Arabia and the rest of the Middle East oil cartel pumping oil with full gusto led to sharp drop in oil prices. In fact, Saudi Arabia is home to the largest oil reserves in the world from which it pumps the commodity in a much more cost-effective manner (by comparison shale gas production is costlier). So even if costs fall too low, it remains profitable for Saudi Arabia.

The supply glut caused oil to crash to $27 per barrel in 2016. However, it recovered from the low to more than triple its price partly due to an agreement among oil producing nations in the OPEC to cut production.

But that didn’t help curb the constant downward pressure on prices.

In this year itself, the US output has surged by almost a quarter. The U.S. crude inventories soared by 10.3 million barrels in the week to 9th November to 442.1 million barrels. This is the highest reached since early December 2017 and resulted in oil prices falling by around a quarter since early October, taking many by surprise.

Demand side

On the demand side, slowing global economic growth and a looming trade war between China and the US have led to concerns over lessening sales in the next couple of years. Meanwhile, under pressure from big oil consuming nations like China and India and the Trump administration as well (ahead of US sanctions on Iran), the Saudi led cartel decided to check soaring prices.

Last but not the least, a strong dollar is also playing a role in dampening demand. Being denominated in dollars, it is making it expensive for nations to purchase oil. A weaker dollar, on the other hand, drives up demand.