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Macroeconomic Drivers of the Price of Oil on the Supply Side

With oil prices having a large effect on the Canadian dollar and GDP growth, it is important for investors and financial professionals to understand the macroeconomic variables and geopolitical actions that can influence the oil price. However, everything can be boiled down to something that affects 1) demand; 2) supply; and 3) inventory.

The price of oil can be looked at as an Econ 101 supply-demand curve. When demand for oil rises, the demand curve shifts to the right and pushes prices up. If more supply is brought on (a new large oil project starts) and demand is the same, the supply curve shifts to the right and pushes the price of oil down. When a consumer of oil (such as a refinery) wishes to use oil but not purchase it or is unable to purchase it, it can draw down on inventory.

When evaluated at a more granular level, a simple supply-demand diagram does not perfectly describe the oil price because oil megaprojects take time to come online and offline and taps cannot be turned off in a hurry if prices fall below marginal variable costs in the short run, so certain producers may run at a loss. Also, certain state owned projects in command economies (China) may produce at a loss for certain projects for social harmony (as opposed to job cuts).

Inventory levels themselves will signal to the market as to where the oil price may go. Usually higher than expected inventory draws will result in a rise in the oil price and higher than expected reported inventories may result in a fall in the oil price.

OPEC or Organization of Petroleum Exporting Countries

OPEC is a group of countries, mostly developing regimes, with large hydrocarbon reserves. OPEC is heavily concentrated in the Middle East, where the vast majority of the oil is extremely low-cost. The most prominent members of OPEC are Saudi Arabia and Iran. Russia is not a member of OPEC but will take part in conversations for an “optimal” oil price.

OPEC, in theory, operates as a cartel. As such, members will determine what level of production they will commit to in order to maximize revenues. However, as with other cartels, there is always the temptation to cheat if production is being curtailed collectively.

For instance, if Iran has a quota for 3 million barrels and has excess spare capacity and the oil price is $60, every incremental barrel is an extra $60 in government coffers. Since oil trading is opaque and volumes publicized may not be accurate intentionally or otherwise, this has historically been a roadblock in OPEC operating as a successful cartel.

OPEC members, being geopolitically less stable than the US or Canada, can sometimes have a large amount of production taken offline at any given moment – for instance, Libya has warring factions within the country which can take away hundreds of thousands of barrels per day of sweet, light crude. When ISIS advanced close to Baghdad in Iraq, risk premiums drove oil to $115 per barrel.

The Breakeven Barrel

OPEC nations are overwhelmingly developing nations with a high dependence on oil revenue to support government spending and welfare initiatives to keep the population in check. As such, the financial media has often referred to a breakeven price of oil – or the dollar price of a barrel of oil that will make the government’s budget balance given steady production.

This term is very confusing, because the cost of extraction plus a required rate of return is also called a breakeven barrel – and one that is relevant in making production decisions. Talking heads and forecasters will often give flawed commentary on how certain OPEC members will cut production because they are not meeting their budget breakeven oil prices – this is an incorrect way of looking at OPEC actions because their goal is to maximize revenue, and at any given time the price-volume nature of the revenue function may not necessarily point to a cut (if price rises but volume falls, it may actually yield less revenue).

From an oil perspective, it is ok to ignore this breakeven barrel concept, but it may be useful for other macroeconomic bets related to rates and foreign exchange.

OPEC Today and Competition from Shale

OPEC’s influence on the oil price as 2020 approaches has waned considerably since the 1980’s. This is because OPEC is no longer an effective swing producer for two reasons.

  • There have been substantial new discoveries in non-OPEC nations and technology has made them accessible and cost effective
  • Shale technologies (including advances in seismic technology) and hydraulic fracturing (“fracking”) techniques allow for precision in drilling and much more certainty in estimates (when oil is found, the amount of oil produced can be accurately measured) – fracking plays can also be exploited very quickly, as opposed to large capital intensive projects such as the oil sands mines.

As such, if the oil price will have natural ceilings as once the price hits $50, $55 or whatever threshold, there are shale projects that become immediately economical that can begin pumping oil in a very short period of time.

Other Considerations

Oil is traded in US$ but is a global commodity. If the USD appreciates, the price of oil will fall, all things equal.

Related Reading for Energy

EnergyGlobal Oil Supply and Inventory Primer · Chinese Energy Companies in Canada · Oil and Gas Demand · Trends in Oil & Gas · Oil & Gas/Energy IB · IB and Finance in Calgary · Macroeconomic Drivers of the Price of Oil on the Supply Side · Common Oil and Gas IB Interview Questions · Natural Gas Supply and Demand Primer · Crude Oil & Natural Gas ·
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