me assignment_crude oil

8/4/2019 ME Assignment_crude Oil

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Demand and Supply of

Crude Oil

Submitted By Group E:

Bhagyashree Aggarwal 2011053

Dipen narula 2011066

Gusain dheeraj singh 2011083

Esheeta Ghosh 2011071

K. Anurag Vinayak 2011095

SUBMITTED TO:

DR. Gajavelli V S


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Table of Contents

1. INTRODUCTION ........................................................................................................ 4

2. DEMAND DYNAMICS OF CRUDE OIL .......................................................................... 7

3. SUPPLY DYNAMICS OF CRUDE OIL ............................................................................ 8

4. SUPPLY SIDE DISRUPTION: ........................................................................................ 9

5. PRICE ELASTICITY OF CRUDE OIL ............................................................................. 11

6. PRODUCTION AND CONSUMPTION OF CRUDE OIL .................................................. 13

7. CRUDE OIL MARKET DYNAMICS .............................................................................. 14

8. CONCLUSION.......................................................................................................... 19

9. BIBLIOGRAPHY ....................................................................................................... 20


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1.INTRODUCTIONPetroleum or crude oil is a naturally occurring, flammable liquid found in rock formations in

the Earth consisting of a complex mixture ofhydrocarbons of various molecular weights, plus

other organic compounds.

The price of crude oil generally refers to the spot price per barrel (159 liters) of either wti or

light crude as traded on the New York Exchange or ofBrent as traded on the Intercontinental

Exchange (ICE).The price of a barrel of oil is highly dependent on both its grade, determinedby factors such as its specific gravity or API and its sulphur content, and its location. Other

important benchmarks include Dubai, Tapis, and the OPEC basket. The Energy Information

Administration (EIA) uses the imported refiner acquisition cost, the weighted average cost of

all oil imported into the US, as its "world oil price".

The demand for oil is highly dependent on global macroeconomic conditions. According to theInternational Energy Agency, high oil prices generally have a large negative impact on theglobal economic growth.

The Organization of the Petroleum Exporting Countries (OPEC) was formed in 1960 to try and

counter the oil companies cartel, and had achieved a high level of price stability until 1972.

The price of oil underwent a significant decrease after the record peak of US$145 it reached inJuly 2008. On December 23, 2008, WTI crude oil spot price fell to US$30.28 a barrel, thelowest since the financial crisis of 20072010 began, and traded at between US$35 a barrel andUS$82 a barrel in 2009. On 31 January 2011, the Brent price hit $100 a barrel for the first timesince October 2008, on concerns about the political unrest in Egypt.

The global prices of crude oil are influenced by a number of factors. The price is directly

related to the demand and supply, both of which are highly dynamic when it comes to crude

oil. Apart from demand and supply, there are other factors such as Government regulations, oil

embargo which also influence the global price levels. Government can try to control prices

through rationing and price caps, but all that does is create shortages.
http://en.wikipedia.org/wiki/Earthhttp://en.wikipedia.org/wiki/Hydrocarbonhttp://en.wikipedia.org/wiki/Organic_compoundhttp://en.wikipedia.org/wiki/Brent_Crudehttp://en.wikipedia.org/wiki/Intercontinental_Exchangehttp://en.wikipedia.org/wiki/Intercontinental_Exchangehttp://en.wikipedia.org/wiki/Barrel_(unit)#Oil_barrelhttp://en.wikipedia.org/wiki/API_gravityhttp://en.wikipedia.org/wiki/Benchmark_(crude_oil)http://en.wikipedia.org/wiki/OPEC_baskethttp://en.wikipedia.org/wiki/Energy_Information_Administrationhttp://en.wikipedia.org/wiki/Energy_Information_Administrationhttp://en.wikipedia.org/wiki/Weighted_meanhttp://en.wikipedia.org/wiki/International_Energy_Agencyhttp://en.wikipedia.org/wiki/Economic_growthhttp://en.wikipedia.org/wiki/Organization_of_the_Petroleum_Exporting_Countrieshttp://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%932010http://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%932010http://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%932010http://en.wikipedia.org/wiki/Brent_Crudehttp://en.wikipedia.org/wiki/2011_Egyptian_protestshttp://en.wikipedia.org/wiki/Egypthttp://en.wikipedia.org/wiki/Egypthttp://en.wikipedia.org/wiki/2011_Egyptian_protestshttp://en.wikipedia.org/wiki/Brent_Crudehttp://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%932010http://en.wikipedia.org/wiki/Organization_of_the_Petroleum_Exporting_Countrieshttp://en.wikipedia.org/wiki/Economic_growthhttp://en.wikipedia.org/wiki/International_Energy_Agencyhttp://en.wikipedia.org/wiki/Weighted_meanhttp://en.wikipedia.org/wiki/Energy_Information_Administrationhttp://en.wikipedia.org/wiki/Energy_Information_Administrationhttp://en.wikipedia.org/wiki/OPEC_baskethttp://en.wikipedia.org/wiki/Benchmark_(crude_oil)http://en.wikipedia.org/wiki/API_gravityhttp://en.wikipedia.org/wiki/Barrel_(unit)#Oil_barrelhttp://en.wikipedia.org/wiki/Intercontinental_Exchangehttp://en.wikipedia.org/wiki/Intercontinental_Exchangehttp://en.wikipedia.org/wiki/Brent_Crudehttp://en.wikipedia.org/wiki/Organic_compoundhttp://en.wikipedia.org/wiki/Hydrocarbonhttp://en.wikipedia.org/wiki/Earth


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Demand and Supply Concept:

Supply and demand are the forces that make market economies work. They determine thequantity of each good produced and the price at which it is sold. A market is a group of buyersand sellers of a particular good or service. The buyers as a group determine the demand for theproduct, and the sellers as a group determine the supply of the product.

Demandis the quantity demanded of any good, which is the amount of the good that buyersare willing and able to purchase.

What determines the demand of a particular commodity/product by an individual?

1.Price: The demand for a particular commodity falls as the price rises and rises as the pricefalls, thus we learn that the quantity demanded is negatively related to the price. Law ofdemand says that keeping other things constant, when the price of a good rises, the quantitydemanded of the good falls.

2 . Income: A lower income means that one has less to spend in total, so one would have tospend less on some, and probably most, goods. If the demand for a good falls when incomefalls, the good is called a normal good. If the demand for a good rises when income falls,the good is called an inferior good.

3.Price of related goods: When a fall in the price of one good reduces the demand foranother good, the two goods are called substitutes. Substitutes are often pairs of goods that areused in place of each other, such as hot dogs and hamburgers.When a fall in the price of one good raises the demand for another good, the two goodsare called complements.

Demand Schedule and Demand Curve:

ADemand Schedule is a table that shows the relationship between the price of a good andthe quantity demanded.

Demand curve, which graphs the demand schedule, shows how the quantity demanded ofthe good changes as its price varies. By convention, the price is on the vertical axis, and thequantity demanded is on the horizontal axis. The downward-sloping line relating price andquantity demanded is called the demand curve. Because a lower price increases thequantity demanded, the demand curve slopes downward.


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Supply is the amount/quantity of goods or services the sellers are willing and able to sell.

What determines the quantity an individual supplies?

1.Price: The quantity supplied rises as the price rises and falls as the price falls, thus wesay that the quantity supplied is positively relatedto the price of the good. This relationshipbetween price and quantity supplied is called the law of supply: Other things equal, whenthe price of a good rises, the quantity supplied of the good also rises.

2.Input Prices: The supply of a good is negatively related to the price of the inputs used tomake the good.

3. Technology: Technological advance reduces the cost of production thus increasing supply.

Supply Schedule and Supply Curve:

A Supply Schedule is a table that shows the relationship between the price of a good andthe quantity supplied.

A Supply Curve is a graph of the relationship between the price of a good and the quantitysupplied. The curve relating price and quantity supplied is called the supply curve.


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2.DEMAND DYNAMICS OF CRUDE OIL1.Rising demand in developing countries:

The demand of crude oil is on the rise in the developing countries. Countries such as India and

China have been consuming a large quantity of oil. This consumption has driven a very high

demand from these two countries, which has led to an increase in the price of crude oil

globally. Strong economy is still necessary to keep oil prices high, but it seems the United

States is no longer oil's main driver. So while growth in oil consumption is nearly flat in the

rich world, developing nations are eating up more and more fuel, India and China being the

major players. Even the subsidies in many developing nations are keeping demand artificially

high. Because of the increase in demand by the developing nations the supply is gettingaffected. In 2008 China, India, Russia and the Middle East for the first time consumed more

crude oil than the U.S., burning 20.67 million barrels a day this year, an increase of 4.4% over

year earlier levels, according to the International Energy Agency. U.S. demand will contract

2% to 20.38 million barrels daily, the IEA forecast.

2. Seasonality Effects:

Refined product prices are influenced by the seasonal change in demand for specific refinedproducts in the major markets of the northern hemisphere, such as the US, Europe and Japan.

The demand of oil in US goes up in the winter and comes down in summer. This is cyclical

change in demand from summer to winter. In the northern hemisphere winter, the demand for

diesel and kerosene to heat homes and offices increases; in the summer the demand for

gasoline increases since people tend to drive more.


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3.SUPPLY DYNAMICS OF CRUDE OIL1.Limited oil reserves (181.6 trillion cubic meters):The oil reserves all over the world are limited. It is about 181.6 trillion cubic meters. The

demand for the crude oil is increasing but due to limited supply, there is an imbalance which is

leading to price hikes.

2.Limits in global oil refining capacity (86.6mb/d) :In order to try meeting the growing demand for refined products, refineries around the world

are now running at near full capacity. Looking to the future, new refineries will need to be

built to continue to meet demand. A key factor in the development of new refineries is thesignificant investment required to build and operate them, which is also increasing due to more

stringent environmental standards globally, both in terms of environmental performance at

refineries and cleaner fuels.


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4.SUPPLY SIDE DISRUPTION:1.Market Speculation:Crude oil and refined product are traded on the open market and are therefore subject to market

speculation, which impacts prices. In recent years, there has also been new entrants and

increased interest in the oil commodities market, mainly from investment funds and hedge fund

managers. It is widely believed that this has added to the volatility of oil prices.

2. OPEC Cartel:OPEC being a cartel has a significant market compared to non-OPEC players. Due to this,

decisions taken by OPEC closely affect oil pricing & every industry across the globe. It is a

form of monopoly which exercises its power through its sheer size. By simply holding supply it

increases its price alongside increasing demand for crude oil. Due to the above there are

significantly less players in the market. The equilibrium between demand & supply keeps

shifting its origin.

3. Currency Fluctuations:Currency fluctuations also affect the demand and supply of crude oil. Oil is purchased in

dollars so with the dollars price going up it will have an impact on the value of Indian currencyhence the demand will get affected. If the dollar price increases then the purchase price of the

oil will increase and hence the demand for oil will decrease and vice versa.

Geo-Political Risks:

In a market with tight spare capacity and low forward cover in terms of days of supply, further

risks introduced by geopolitical instability in many OPEC, as well as non-OPEC countries put

additional upward pressure on inventory demand and crude oil prices. A lack of political

stability continues to threaten production in several OPEC nations, including Iraq, Nigeria,

Venezuela, and Iran.


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1. Unpredictable / extreme weather events:Extreme weather events, such as hurricanes in the US can temporarily reduce global

refining capacity. Such reductions and speculation about availability of refined products have

caused volatility in refined product prices globally. Hence the demand and supply gets affected.

2. Subsidies by Asian countries:Political pressures and inflation concerns continue to prevent many countries particularly in

Asia, where inflation has become an acute problem from ending subsidies and letting

domestic prices bounce up and down. Many countries, like India, have raised oil prices

considerably in recent months, only to watch world prices climb even further, pushing up the

cost of subsidies. In most countries that do not subsidize fuel, high prices have caused oil

demand to stagnate or fall, as economic theory says they should. But in countries with

subsidies, demand is still rising steeply, threatening to outstrip the growth in global supplies.

Indeed, the biggest question hanging over global oil markets these days may be how much

longer countries can keep paying the high cost of subsidizing their consumers. If enough

countries start passing the true cost of oil through to their citizens, many economists believe,

demand growth will slow, bringing the oil market into better balance once again, lowering

prices. Therefor with increase in price, the demand decreases and affects the supply.


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5.PRICE ELASTICITY OF CRUDE OILPrice Elasticity is the ratio of the percentage change in a dependant variable to the percentage

change in the independent variable. Price elasticity measures the degree of responsiveness ofquantity demanded of a product to change in its price given the consumer income, his tastes

and prices of all other goods.

Determinants of price elasticity:

1.Availability of substitutes:The most important factor affecting elasticity of demand is the extent to which the closed

substitutes are available for commodity. If the close substitutes are available then a small rise inprice will have a large effect on consumption. Similarly a commodity having no close

substitute is likely to have an inelastic demand. Therefore, since crude oil doesnt have a close

substitute the demand is inelastic.

2. Number of Uses to which a commodity can be put:Second major factor influencing the elasticity of demand is the number of uses it can be put to

Commodity which has various uses will have a relatively elastic demand. Conversely if a

commodity has restricted uses it tends to have inelastic demand. Crude oil has various uses

such as in oil chemicals, plastics, medicines, fertilizers, foodstuffs, plastic ware, paints etc.Therefore, crude oil has an elastic demand.

3.Nature of the need that a commodity satisfies:Generally for necessities the demand is relatively inelastic while for luxury goods it is

relatively elastic. Since crude oil is a necessity for a country the demand is relatively inelastic.

4.Proportion of income spent on the Good:Other things remaining the same the higher the proportion of income spent on the good the

more elastic is the demand for it. As in case of crude oil it is different for different classes.

5. The Time allowed for adjustment:The longer any price change remains, the greater the price elasticity of demand. Conversely,

the shorter any price change remains, the lesser the price elasticity of demand. In long run the

elasticity is high as people can shift to alternatives such as solar, nuclear or water etc. But in

short run the response of buyers to a change in the price of a good before sufficient time has

elapsed for all possible substitutions to be made.


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6.Relative importance of a commodity in the expenditure of consumer:If the purchase of a commodity forms a significant percentage of a persons total expenditure

either because its price is high or because the amount consumed is large, then his demand for it

is likely to be more sensitive to price changes than if the commodity occupies an insignificant

proportion of his expenditure. Therefore if the oil consumption forms a significant percentageof a persons total expenditure than the demand for it is more sensitive to price changes.


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6.PRODUCTION AND CONSUMPTION OF CRUDE OILThe world's top five crude oil-producing countries are Saudi Arabia, Russia, United States, Iran

and China.

The amount of crude oil produced (domestically) in the United States has been getting smaller

each year. However, the use of products made from crude oil has been growing, making it

necessary to bring more oil from other countries. About 58 percent of the crude oil and

petroleum products used in the United States comes from other countries.

India has over 3,600 operating oil wells, according to OGJ. Although oil production in India

has slightly trended upwards in recent years, it has failed to keep pace with demand and is

expected to decline.

The combination of rising oil consumption and relatively flat production has left India

increasingly dependent on imports to meet its petroleum demand. In 2006, India was the

seventh largest net importer of oil in the world. With 2007 net imports of 1.8million bbl/d,

India is currently dependent on imports for 68 percent of its oil consumption. The EIA expects

India to become the fourth largest net importer of oil in the world by 2025, behind the United

States, China, and Japan.

The government of Indias largest crude oil import partner is Saudi Arabia, followed by Iran.

Nearly three-fourths of Indias crude oil imports come from the Middle East. The Indiangovernment expects this geographical dependence to rise in light of limited prospects for

domestic production.


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7.CRUDE OIL MARKET DYNAMICS The petroleum market in the 1990s exhibited several features that allowed for thees

t

ablishment

ofquant

itative insight

s between crude oil prices and market

fundamen

t

als.Over much of the time between 1990 and thepresent, OPEC did relatively little to adjust

production to accommodate demand changes, and sometimes, when action was taken, it was

either insufficient or excessive. Thus, there has been a fairly long period in which prices

exhibited some rather large cyclical swings, as shown in Figure 1.

Figure 2 shows how OECD crude oil supply and demand for petroleum varied over thelast decade. Global demand for petroleum products is highly seasonal and is greatest

during the winter months, when countries in theNorthern Hemisphere increase their use ofdistillate heating oil and residual fuels. Supply of crude oil, including both production

and net imports, also shows a similar seasonal variation but with smaller magnitude.

During the summer months, supply exceeds demand and OECD petroleum inventoriesnormally build; whereas during the winter, demand exceeds supply and inventories are

drawn down. As a result, inventories also demonstrate seasonality. If market supply and

demand is balanced over the period of a year, the increase in inventories over the summer

will equal thedecline ininventories during thewinter.

As indicated in Figure 2, the market was well out of balance in 1998 due toslowing demand growth and increasing supply. Two warm winters and the Asian

financial crisis diminished demand growth both seasonally during thewintermonths and

over the entire year, while supply increased substantially as Iraqi crude oil came back

into the export market in 1997 through the Oil-for-Food Program. During this time,

supply outstripped demand and inventory grew to unusually high levels.

Figure 1: Monthly Average WTI Crude Oil SpotPrice


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Figure 2: OECD Crude Oil Supply and PetroleumDemand

Figure 3: Total OECD PetroleumInventory


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From Figure 1, it is observed that WTI crude oil spot prices fell to near $10 per barrelby the end of 1998, due to the excess of production over demand and the resulting

inventory build. In March 1999, OPEC agreed to cut back production to a level well

below demand, and also during this time, the Asian economies had an unexpectedlyquick recovery, which increased the demand for crude oil. Thus, during 1999, the supply-

demand imbalance reversed, and with demand exceeding production, inventories were usedto help meet demand. The excess inventories that had been built up fell rapidly to below

normal, and WTI crude spot prices rose to over.

From Figure 3 we can see how total OECD petroleum inventories, defined as the sum ofgovernment stocks and commercial stocks of both crude oil and petroleumproducts, have

changed over time. In particular, note the large excess and then underage of inventories

over the past several years relative to variations away from some kind of normal level

seen in the f i rst halfof the decade. Such an observed normal level in OECD inventories is

theoretically as well as empirically important when exploring inventory relationships to

price. If the peak inventory level reached during the summer months is lower than normal, itindicates less-than-normal inventory will be available to supply the upcoming high-demand

winter months, and prices would be expected to increase.

The relative inventory level will be defined as the deviation of actual inventories froma well-defined normal, or desired, level in the next section. Then, the desired normallevels will be empirically determined and the relative inventories will be derived inthe fourth section. Inventories are seasonal as seen from Figure 3, often building in thesummer months and dropping during the winter. As has been explained previously,inventories demonstrate seasonality because their build-ups and draw-downs reflect theseasonal imbalance between supply and demand as a result ofthe supply of crude oil showingless seasonal variation than demand. Long-term trends also exist, mainly due to the trendsin governmentinventories.

It has been observed that petroleum inventories have the following characteristics:1. Inventories of crude oil are readily available to refineries (petroleum product

manufacturers) for production of products such as gasoline and distillate

heating oil, and inventories of primary petroleum products are readily available

to be sold to end users.

2. Prices seem to be more responsive in the short-term to inventories than toproduction because inventories are the marginal source of supply.

3. Inventories are needed to cushion a system that delivers products in batches.Fourth, companies build or draw down discretionary inventories based on theirprice expectations and sale opportunities.

4. Inventories also build or fall due to uncertainties or unexpected changes inproduction and demand.

Regardless of the cause of their change, inventories provide a measure of whetherproduction is in excess of demand, how much in excess, and for how long. As such,

inventory behaviour can be an indicator ofmarket pressure on price changes. In the case

ofpetroleum, when crude oil production and refinery production exceed demand for crudeoil and petroleum products, commercial inventories of crude oil and products will build


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and vice versa. Specifically, for the world market, assuming no losses or volume changes

during processing, the following balance equation can be written:

Demandt= P roductiontInventoryChanget (1)

Since, Inventory Changet= Inventoryt

Inventoryt

1, (1)

implies: Inventoryt= Inventoryt1(DemandtProductiont) (2)

As shown in Figure 4, and assuming initial equilibrium inventories, if demand exceeds

production in a given month, inventories will be drawn down below desired normal

levels and there will be positive price pressure. The direction and speed with which

inventories are changing indicate the direction and magnitude of the demand and supply

imbalance. For example, during spring and summer months, it is typical industry practice

to replenish product inventories by refining more products than are demanded. This

invent

ory increase is normal and expected, and would result in no price pressure. It is only insituations where the inventories are not being built to desired normal levels that positive price

pressure would exist.

It is importantto note that the equilibrium price in a given month is at the point wherethe difference between supply and demand is normal, taking into account any possible

seasonality and trend. In other words, the equilibrium price is achieved when the relative

inventory level, defined as the deviation of actual inventory level from its corresponding

desired normal level, is zero. The concept of relative inventory level is crucial. It indicates if

the market is tight or loose, and thus indicates increases or decreases in price pressure.

The goal of this paper is to build a forecast model based on the relationship between thecrude oil price and the relative inventories ofpetroleum.

The fundamental assumption in the analysis is that there is a relationship between price andsupply-demand fundamentals. The relative inventory variable is an explicit measure of thebalance between production and demand. Thus, relative inventory is a good variable toindicate the state ofthe supply-demand balance as it impacts price.

Figure 4: An Illustra

t

ion of Supply, Demand, and Inventory Behavior on Price


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Figure 5 shows the desired normal level of total OECD inventories as compared to theobserved level. This empirically determined normal level demonstrates a positive trendand

the expected seasonal movements. The difference between the observed inventory level and

the corresponding desired normal level is the so-called relative inventory level or the de-seasonalized and de-trended inventory level, reading from the right vertical axis in the

figure.

Figure 5: The Normal Level of OECD PetroleumInventory


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8.CONCLUSION1. The price of oil may not go below $75.2. If OPEC does not indulge in artificial rate hikes, then while that lasts oil prices will go upbroadly in line with the growth of world GDP in nominal dollar prices, if as is commonly

believed, world oil production has peaked and it will flat-line for the next five to ten years.

3. If the flat-line starts to dip dramatically, then oil prices will start heading up towards the long-term replacement cost; long term as in the cost to get out the really expensive oil, which if goldis any guide is $138 in current (2010) prices.

4. There could be a period when the supply of oil to the world goes down at least 25% if oilproducing nations face a large threat such as Iraq in 2003.

5. Based on the 1980s bubble, when there was a 25% drop in production, that suggests a 25%reduction in consumption would lead to a 2x bubble in price (over the fundamental), plus a 33%increase in fundamental due to the drop in production.

6. The prices of oil may grow at 10% in the next decade, which is a healthy rate, in case thereare no unforeseen swings in the inventory.

7. The upward price swing will cause maximum problem in developing countries such as India.


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9.BIBLIOGRAPHY www.wikipedia.com www.wtrg.com Forecasting crude oil Spot Price Using OECD Petroleum Inventory Levels , by

Michael Ye, John Zyren, and Joanne Shore, International Advances in Economic

Research, Nov 2002

What do we learn from the Price of Crude Oil Futures by Ron Alquist, University ofMichigan, Lutz Kilian, University of Michigan.

me assignment_crude oil

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