Price of Oil and its determinants
Oil Demand and Supply in Canada
Canada is one of the biggest contributors to the Oil industry. Canada is both a producer and a consumer of oil and, therefore, significant in determining the price of oil both in Canada and other parts of the world. The oil and gas companies in Canada are pressed with varies issues, including regulation of the price of oil as well as regulatory framework requiring the companies to reduce emission. In several instances in the history of the Canadian oil industry, the industry has been faced with dramatic changes in oil prices.
Nandha and Faff (2008) note that, in some cases, the Canadian oil market responds to the global forces, but the prices in other times are only determined by what is happening in Canada only. Several studies have been used to explain the fluctuation in oil prices both in the Canadian market and in the global context. However, there has been no exact agreement among the scholar on what are the exact forces that result in changes in oil prices.
Some of the mentioned factor determining oil prices includes the laws of demand and Supply, the structure of the oil industry, and the match between the marginal cost and the oil demand. The regulatory framework in any particular country also has an effect on the prices of oil in any particular setting. The question remains, what the actual determinants of the oil prices are. This paper aims to analyze the changes in oil prices as well as the determinants of these prices both in the Canadian market and from a global perspective.
An Overview of the Canadian Oil Industry and a Brief Description of the Market Players
A good understanding of the determinants of the oil prices will require a review of the market structure itself as well as an understanding of the main players in the industry. The Canadian oil industry is mainly controlled by private companies but is regulated by the government through Canada’s National Energy Board (NEB) and Environment Canada, among other agencies.
Canada is ranked as the 6th largest producer of oil globally. Despite being of the producers, the country has witnessed price fluctuation throughout the history of the oil industry in Canada. The main players in the Canadian Oil industry are the extracting companies, the government through various regulatory agencies, the oil suppliers and exporters, and the consumers. All these players have a role in determining the oil prices in Canada.
Figure 1: Oil Price changes in Canada in 1985-2018 (Prices are in US$).
A focus in the chart above indicates constant changes in prices of crude oil in Canada from 1985 to 2018. The oil prices in Canada are much lower as compared to prices in numbering countries such as in the United States. The question, therefore, we should focus on are the determinants of this oil prices.
Price of Oil Determinants: Theoretical Background
Badr and El-khadrawi (2016) explain that several theoretical frameworks have been put across by scholars and experts to explain the changes in the prices of oil. The theoretical framework explanation of the determinants of the prices of oil can be divided into the short-term equilibrium, the medium-term equilibrium, and the long-term equilibrium.
The Law of Demand and Supply
In the simplest commodity model, the prices of goods and services are determined by the interaction between the Demand and Supply of the commodity. This model can be used to explain the determinants of oil prices. From this model, therefore, we note that the two common determinants of oil prices are the quantities demand and quantities supplied. However, it worthy to note that this model best works in a perfect market, which is not the case for the oil market.
The demand and the supply of oil products determine the equilibrium prices of the oil. It is essential to discuss how the Supply and the demand for oil products are determined. Sadjadi and Sadi-Nezhad (2017) note the demand for oil products are significantly inelastic. The demand for oil is determined by other factors other than the prices of the product. For example, the demand for oil will be dependent on fuel consumption in a household or a country in a wider perspective rather than the prices of the product. Economic activities and other environmental factors determine the demand for oil. The oil supply is also inelastic and determined by other factors other than the prevailing market prices of the product. The structure of the oil production in Canada, just like in many other countries, comprises a condition where the variable cost only comprises a small fraction of the total production costs. The total production cost is mainly composed of fixed capital depreciation.
Since the years 2000, the world prices of oil have significantly increased. The reason for the increase in prices can be seen as the increase in the demand for oil products resulting from the rapid development of China and other developing countries across the globe. Such changes have gone further to result in changes in the oil prices in Canada, with the price of one barrel of oil hitting 100 dollars in 2015. The growth in the energy demand was not matched with the Supply and therefore increasing the prices of oil. However, higher prices in the last decade have resulted in an increase in the oil supply since such increases the appetite for massive exploration and mining of oil. Such development includes the development of higher-cost sources such as deep-water offshore extraction, US shale oil, and Canadian bitumen. CERI (2016) note that this change in the world’s oil market is one of the proofs that demand and supply of oil and oil products are among the determinants of the oil prices both in Canada and in the global perspective.
Global politics, oil demand and Supply, and oil prices
The oil prices are also affected by global politics and another major happening around the globe. Major wars and economic and financial crises affect the oil prices mainly through the Demand and Supply of the product.
The oil prices in Canada are affected by what is happening in the global context. For example, the Iraq/Iran war happening in 1980 to 1988 heavily affected oil prices both in Canada and in other parts of the world (Halog and Chan, 2008). Given that Iraq and Iran are among the oil producers, the conflict-affected the Supply of the product, increasing the price of the product. Other global political issues that increased oil prices include the Gulf war, the low spare capacity, and the recession in 2008, and the Libya uprising.
Structure of the Industry
Sadjadi and Sadi-Nezhad (2017) explain that in the theory of industrial organization, the structure of the industry is used to describe the nature and competitiveness of the industry. In this theoretical framework, the nature of the industry is determined by basic factors that affect Supply and demand of the products, factors which include the legal, institutional, and socio-political environment in which the players in the market operate. Theoretically, firms will decide on the amount to produce and supply based on the current structural situation, a decision that affects the industry performance, including characteristics such as prices and the volume of the products supplied. The analysis of the industry structure and its effects on prices has evolved through several stages.
The market theory initially concluded that the market structure, and especially the oil industry, is determined by the number of firms in the industry. Under this theory, the few firms in the industry, the more likely that such firms will collude and control prices in the market. This happens under oligopoly and monopoly market structure. However, under the competitive market where the numbers of firms in the industry are many, the prices, supplies, and demand are influenced by the market forces.
In this case, therefore, there is the possibility of the formation of cartels to control the prices of the products. For the case of the oil industry, the cartels are not formed by the firms operating in the oil industry but by the oil-producing countries. The countries under OEPC control the prices of oil by regulating the amount of oil they produce and therefore affecting the prices of the product globally. Given that oil is a product that is used by many people across the globe, such effects with feeling all over the world, including in Canada.
Marginal Production cost and Oil demand and Supply
Elysian, Mansur, and Odusami (2011) explain that there are a lot of changes in the market in the long-run. Factors such as production technology, production zones, and petroleum consumption patterns may change in the oil industry. In the long-run, therefore, the cost of producing oil is a variable factor, and if the firms in the industry do not meet the profit margin targets, they will abandon the industry. The producers with higher costs will opt to abandon the industry and therefore reducing supplies. Such will push the prices upwards. In the long-run, however, the market price falls around the production cost.
Apart from the theoretical framework explaining the changes in the prices of oil, there are other determinants of oil prices, which come from the oil industry regulatory framework. For example, there are factors that interrupt the Supply of oil, which are not determined by the market forces. In the current global crude oil market, the Supply of the product is determined by the Supply by the non-OPEC and the OPEC. The non-OPEC will produces their capacity without considering the market prices will the OPEC will just produce enough to keep a certain price against a target band (Elyasiani, Mansur, and Odusami, 2011). The cartel countries, therefore, affect the prices of the product by placing production quotas, whose main aim is to control the prices of the product.
The regulation of the oil industry in Canada has affected the prices of the product in the country. For example, CERI (2016) notes that the companies in the country are squeezed by pressure by the regulatory agencies to reduce emissions and the control of the prices. Strict regulatory requirements to reduce the environmental effect of oil production increase the cost of production, which in turn can be passed to the consumers through increased prices. Justin Trudeau’s government seeks to support the oil-producing companies in this period when the price of oil is decreasing but must meet Canada’s emission output requirements for environmental concerns. This is likely to come with a higher production cost, which is likely to affect several industry characteristics, including prices.
Exchange rates and Inflation
Market forces such as exchange rates and inflation affect oil just as it does to other products supplied in the markets. Oil is produced and consumed in many countries across the world. It is among products that are heavily imported and exported across all parts of the world. Therefore, the prices of this product are subject to exchange rate risks. The prices are affected by what is happening in the foreign exchange markets. If the Canadian dollar depreciates, the product will have lower prices in the country in which Canada exports the product. However, in a scenario where Canada would import either oil or oil products, an appreciation of the Canadian dollar will mean that the product will be more expensive locally.
Financial Speculation and Hedging
Speculation and hedging have effects on the prices of oil in Canada as well as in a global context. Alquist and Gervais (2013) note that financial firms have increased their ventures in the future oil market in the last decade. This has come with a considerable increase in the oil prices hitting $100 per barrel in 2015. All the prices in Canada have considerably gone down since 2015; financial speculation can be seen to be one of the factors that would have increased prices of oil. Hedging and hoarding by the OPEC countries have also resulted in changes in the prices of the product both in Canada and other parts of the world.
The oil prices in Canada have greatly fluctuated in the last two decades. In some instances, the changes in prices are consistent with the global forces. However, in other cases, the Canadian oil industry seems to be independent of what is happening in the global context, with the prices in Canada not being influenced much by what is happening in the external world. The oil industry operates under an imperfect market condition with a lot of interference from the government and the cartels in the oil industry. The real question remains, what are the actual determinants of the prices of the product both in Canada and in the global context.
The price of the oil is affected by the forces of demand and supply, just like any other product. The intersection of demand and Supply gives the equilibrium price of the product. The Supply of the product is affected by the geopolitical environment, among many other factors. The prices of oil are also determined by the specific industry structure in the market of concern. If the market is a monopoly or an oligopoly, there are possibilities of conspiracy, with the cartel deciding on the prices of the product. The long-run production cost of oil also affects its prices. Other determinants of oil prices include the regulatory framework, financial speculation, and hedging, cooperation among the oil-producing countries and exchange rates, and Inflation, among many other factors.