Top 10 Drivers
What citizens ought to pay for energy is a contentious issue that can be divisive.
But..
There is one area however where there is no debate and it deals with the fundamentals. It involves the drivers behind what you should be paying for your fuel. This article explores the top 10.
It is all about Demand and Supply
There are two types of energy players across the globe; net producers and net consumers. The outputs and inputs from each of these players constitute global demand and supply. When there is insufficient production to sustain global demand, prices increase as consumers are willing to pay more to obtain scarce resources. When supply is abundant, suppliers have an incentive to reduce their prices to entice consumers. This dynamic leads to price variations that can change on a an hourly basis. Certain production centers are so abundant that they are viewed as pricing hubs. Any market change in these regions create a significant deviation in the demand and supply equilibrium.
So if you want to understand what triggers price changes, one needs to understand what influences demand and supply.
1. Production Profiles
The sum of crude oil produced around the world is global supply. If this amount does not match global demand, prices typically escalate. As of 2019, the top 10 crude oil producers are
1. USA
2. Saudi Arabia
3. Russia
4.Canada
5.China
6. Iraq
7.Iran
8. United Arab Emirates
9. Brazil
10. Kuwait
Countries that have the highest reserves have the greatest impact on prices. If for some reason any of the production centers experience production declines or impediments to bringing product to market, the market reacts quickly and prices can escalate. Inventory has a part to play on prices as well. Typically net importing countries have strategic reserves set aside in case there are any market upsets. If these inventories are drawn down too quickly due to supply bottlenecks, prices rise. For the reverse, if consumption declines, the market becomes oversupplied and prices are likely to be softened. Producers who are members of OPEC (Organization of Petroleum Exporting Countries) are examples of countries that have the greatest influence on price levels. The cartel comprises of 11 members who control 40% of the world's production. They are Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, UAE and Venezuela.
In 2014, the group engaged in a pump war to lower oil prices to make competing shale developments uneconomical. As a result, OPEC's market share rose while oil prices declined to US$30 per barrel. This strategy proved damaging as it also negatively impacted the national budget of these territories. They have since reversed this strategy. Since December 2016 and especially in 2020 due to the Covid-19 pandemic, OPEC and their partner countries have exercised their muscle by putting in place production cuts to maintain oil prices at a levels where they could still balance their respective countries' budget but still defend their market share.
2. Economic Growth
Economic growth is a sign of prosperity. As the economic standing of countries improve, consumption patterns increase. Citizens have more choices and their spending habits become elevated as their standard of living improves. This drives demand. As developing economies grow, so too does their demand for fuel and consumer goods. Economic Development and industrialization have often gone hand in hand as countries have easier access to resources to invest in improving their infrastructure and services. Energy use therefore increases unless energy efficiency policies are adopted. This puts an upward pressure on commodity prices.
Currently the world is facing an economic slowdown and this has had a sobering effect on prices. Economic slowdowns in demand centres such as China has far reaching consequences as exporting territories often depend on populous territories to consume their production. The US/ China Trade war had its part to play in slowing global activity and commodity prices. According to the Washington based Institute of Finance, the two nations have contributed to over 60 per cent of the US$7.5 trillion increase in global debt over the first half of 2019. the spead of Covid-19 has made things worse.
3. Weather
Weather events also affect the price of fuel. Energy is used as a heating fuel and cooling fuel. As the temperature gets colder, there is greater demand for fuel to heat homes so energy prices tend to increase near the winter months. Similarly as temperatures get warmer, there is going to be a greater demand for fuel to keep homes cool or a greater demand for driving fuel as intra country vacations increase. On the occasions when there is reduced weather related demand, product inventories remain high due to reduced storage withdrawals. Product prices tend to be depressed as demand is reduced.
4. Geopolitics
The term Geopolitics dates back to 1899 when it was first coined by political scientist Rudolf Kjellen. It is defined as the analysis of the interaction between geographical settings and political processes. Globalization has come at a price! As the world becomes more connected, the state of international relations can have a overreaching effect on different sectors in particular energy trade. Any dispute or geopolitical competition that could threaten global production, energy assets or distribution systems can impact directly the global supply dynamic. The tit for tat US-China trade war, sanctions against Venezuela and Iran all display how contentious interactions at the international level can impact energy prices. Market prices tend to respond to either the probability of a threat or the realization of a physical disruption.
In late 2014, the price of oil decreased from a period of high prices (around $100/bbl in real 2010 dollars) to an annual average low (under $40/bbl in real 2010 dollars), causing producers to reconsider investments in new locations with higher production costs. The price decline was in part due to an oversupplied market, furthered by an OPEC decision to maintain production levels in November 2014, in part to defend market share. OPEC decisions, political destabilization, financial crisis, and war are some of the world events that can affect the supply and price of oil.
5. Changing Consumer tastes and Regulations
The world is transitioning to a green culture where sustainability driven initiatives are signs of good governance. With the rise of renewable energy demand, electrification of transportation and energy efficient devices, one can expect the demand for fossil fuels to wane in certain economic sectors. The utilization of certain energy sources will change and this will likely influence supply dynamics. Many countries are also trying to reduce greenhouse gas emissions, diversify their fuel mix, and enhance their energy security by reducing dependence on fuel imports so the demand side of the equation will also be influenced. Consumers and shareholders are now making more sustainable investments and demanding that governments promote more sustainable practices. This sentiment also influences environmental legislation and regulations. More countries are adopting laws to encourage more sustainable behaviour. There have been condemnation on the flagrant use of plastics which is derived from fossil fuels. Regulations are also exercising controls on the quality of land and transportation fuels. This is going to have an impact on prices in the future.
6. Transport and Distribution
7. Supply, Transportation and Distribution
Oil is typically transported via pipelines, sea or rail. Any disruption to the crude oil transit systems would have an impact on prices. Supply bottlenecks can reduce open trade, which can conflate prices and access to commodities. For instance, the Government of Alberta instituted a crude oil curtailment policy in January 2019, as crude producers faced export infrastructure bottlenecks. The inability to export excess production caused storage to increase to 35 million barrels of crude oil (nearly double the historical amount) for the Canadian province. This depressed prices as product could not reach to market. Production has to be curtailed as a response.
Events such as hurricanes, tornadoes and droughts can also have a negative impact on energy distribution systems. In those cases prices tend to skyrocket if there is a supply choke. The implications are so significant that the Department of Energy (DOE) in the US released in 2018 their state of the art model built to predict how climate change and weather will impact energy systems in the future.
There are other ways product can be prevented from reaching market. Saudi Arabia controls nearly all of the world’s spare oil capacity (72%) which allows it to respond quickly if it has to increase output to balance markets. Saudi Arabia ships 7 million barrels of oil around the world daily.The attack on Saudi facilities in September 2019, caused the biggest oil supply disruption for more than 50 years. When one of its processing facilities was attacked, 50% (5.7 million barrels) of its output was affected which is 5% of global daily production. Oil prices spiked as much as 20 % in response. The Straight of Hormuz is another example of a critical point of distribution. This waterway between Iran and Oman flows from the Persian Gulf to the Gulf of Oman – and beyond that to the Indian Ocean – and is considered the world’s most important oil transit chokepoint. In 2017, 20.3 million barrels of oil per day were shipped through the Strait and this accounted for approximately a 33% of global maritime oil trade. In 2018 , it accounted for 25% of LNG trade in 2018. (EIA).
8. Financial Speculation
Financial Speculation. Like most other traded commodities, energy prices can be affected by financial speculation. If the performance of the market does not appear to be aligned with supply/demand fundamentals, it is often blamed on speculation. Speculation is viewed to be a reaction by investors and energy traders to expectations of production disruptions, emerging technologies, political unrest and predictions on global growth. These players typically react by buying or selling their commodity stock positions without possessing physical product. This adjustment in inventory holdings creates price volatility in the markets way before an event occurs and is reflective of market sentiment.
9. Project Investment
There can be no exploration and production without investment. Before an investment is made, producers consider world demand growth forecasts. Oil producers attempt to match world demand projections by investments and decommissioning low yield production sites. A high commodity price environment fuels more investments as companies can justify the capital spend and build a case for an investment. When commodity prices drop, so do exploration projects as the cash flow of these companies dwindle. If the prospects for increasing oil consumption appear minimal or if the price outlook looks bleak, then producers may be more hesitant to invest in new fields. Due to the life cycle of these investments (from investment to production), a decision to halt exploration by multiple players could be felt in the market years after the decision has been made. This has the ability to create a supply short if future demand outpaces available production. Investments in more conventional oil were deferred in 2015 after oil prices started their decline late 2014. The IEA has described this as a two speed market. Although production from unconventional supply (shale oil) has been increasing, output from conventional sources have dropped. Given that it typically takes 3 to 7 years from project sanctioning for production to come online there is short fall predicted in 2022 to 2025 which may have an impact on prices.
10. Technology
One of the major game changers for the energy industry in the 21st century has been the rise of hydraulic fracturing and horizontal drilling. Without this technology, shale resources could not have been accessed. This has helped unlock vast energy reserves in Argentina and the US. For the US, it has transformed the US energy sector making it energy independent. This is reflected in its ranking as #1 natural gas producer in the world.
Technology is now performing dual roles. Whilst technology has paved the way for innovations in geological exploration, it has also helped to curb consumption patterns in an environment where everyone's carbon footprint counts. Utilities can now be energy efficient through energy management software and the energy intensive construction sector is now being redefined by software-driven construction in the form of 3D printing.
As you can see there are many factors influencing the price of the energy. They are also reflective of decisions made in territories far away from you or other demand sources. Some of these issues tug and pull at the same time and they create a neutralizing effect on prices. Other times it is skewed and prices can skyrocket. I would suggest that you never take it for granted. Keep monitoring such variables as sooner or later, it can eventually impact the choices you make on how you spend what is in your wallet!
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