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Prices in physical markets are influenced by a myriad of factors. As in most markets, supply and demand play a major role in price determination. Commodity prices are also generally linked to economic performance, with growing economies consuming more commodities, and thus raising prices. Commodity prices are also influenced by events affecting the supply chain of the product, from producers and refiners to distributors and consumers.

As a number of energy commodities are considered strategic assets and their production is concentrated in the hands of a few countries, which are largely emerging economies that can be prone to instability, there is a geopolitical aspect to price determination as well. As commodities get increasingly financialized, with major financial players like banks and hedge funds trading in these markets, commodity prices have also become linked to other asset prices.

Let us examine some of these factors briefly, using the oil markets as an example.

Geopolitical Risks

Oil prices are particularly vulnerable to events such as war, internal strife, or terrorist attacks, especially in the sensitive Middle East region. For example, oil prices spiked in the wake of the Gulf War and the Iraq War of 2003, as well as during the “Arab spring” rebellions across a number of countries in North Africa and the Middle East. In such environments, oil prices trade at a premium to prices implied by supply/demand balance, and this is sometimes dubbed the “fear premium.” In contrast, resource nationalism, in the form of higher royalties or outright nationalization of assets, has been decreasing in recent years and many national oil companies are opening up to collaboration with global oil companies due to the scarcity of capital and technological know-how needed to exploit new reserves.

The Geopolitical Chessboard – The Petrodollar System and Rising China

Earlier in this chapter we discussed the strategic role played by energy resources and touched on how the pricing of this commodity can impact the destiny of large nations. The fact that more than 60 % of the global production of oil moves on maritime routes makes naval power integral to securing the supply of oil and thereby shaping the world's geopolitical chessboard. By far, the USA is the mightiest naval power in the world and has been successful in providing protection to major oil producers and securing the maritime routes, thereby deserving the privileges of the petrodollar system. Other rising powers, like China, have also relied on US-led maritime route security to secure the energy imports required to build an industrial complex and accelerate their economic growth. However, it is only recently that these nations have begun viewing these energy maritime routes as the source of vulnerability that they are and have taken steps to address these weaknesses and reduce their exposure to the petrodollar system.

The Strait of Hormuz, the Strait of Malacca, the Suez Canal, Bab El Mandab, the Danish Straits, the Bosporus and, to a lesser extent, the Panama Straits are the major oil chokepoints, representing the most strategic locations that have shaped the geopolitics of the last 40 years. The most strategic and troubled chokepoint remains the Strait of Hormuz, which has been used as a bargaining card by Iran to negotiate with the West and put pressure on neighboring oil-producing countries.

In the case of China, the world's second-largest oil-consuming nation, the situation is much more complicated, because its oil imports need to move through two major chokepoints and a troubled South China Sea, as shown in Figure 1.4.

FIGURE 1.4 Oil maritime routes and chokepoints

Data Sources: US Energy Information Administration analysis based on Lloyd's List Intelligence, Eastern Bloc Research, Suez Canal Authority, and UNCTAD, using EIA conversion factors. Estimates are for year 2013.

China imports over 70 % of its crude oil from the Middle East and the traditional sea route has been through the Indian Ocean, the Strait of Malacca, and the South China Sea. China remains concerned about its security of sea lanes, especially those passing through the Strait of Malacca and the South China Sea, through which an estimated 80 % of its oil imports transit. Also, in the absence of a significant global naval presence, China is not comfortable relying on oil imports passing through the South China Sea, which is surrounded by countries that are perceived to be part of a US-led containment coalition. These potentially hostile countries include the Philippines, Japan, and Taiwan, which were once referred to as an “unsinkable aircraft carrier” by General MacArthur. As a nation that is not a US ally, China fears the disruption of its oil imports in the case of hostilities in the region.

In order to alleviate the disruption risks, China has done a formidable job developing trade links with its Central Asian neighbors and building infrastructure in close South Asian neighbors to gain access to the Indian Ocean. Together with Pakistan, China has been developing a megaproject called the China Pakistan Economic Corridor (CPEC) consisting of a network of highways, railways, and oil and gas pipelines over 3000 km running from the port of Gwadar all the way to Kashgar in China. The CPEC will give China access to the Arabian Sea not far from the Strait of Hormuz. Similarly, China gained access to the Bay of Bengal via Sino-Burma pipelines, which transport oil and gas from the port of Kyaukphyu to Kunming (Yunnan Province). In addition to cutting the shipping time of Middle Eastern and African crude oil significantly, these two shortcuts are game-changers on the chessboard as they help avoid crowded South China Sea waters and any unexpected hostilities in transit. Additionally, as mentioned earlier, China has also been working closely with its neighbors in the east and the north, signing megaprojects allowing Russia to trade its oil and gas in Yuan or Roubles using trade-offset mechanisms to minimize its dependence on the US dollar and related unpredictability in financing costs.

Oil prices are particularly vulnerable to events such as war, internal strife, or terrorist attacks, especially in the sensitive Middle East region. For example, oil prices spiked in the wake of the Gulf War and the Iraq War of 2003, as well as during the “Arab spring” rebellions across a number of countries in North Africa and the Middle East. In such environments, oil prices trade at a premium to prices implied by supply/demand balance, and this is sometimes dubbed the “fear premium.” In contrast, resource nationalism, in the form of higher royalties or outright nationalization of assets, has been decreasing in recent years and many national oil companies are opening up to collaboration with global oil companies due to the scarcity of capital and technological know-how to exploit new reserves.

Long-Term Supply and Demand

To understand the long-term demand and supply in commodity markets, let us take a look at a few of the indicators that are used.

Production and Reserves

The supply of crude oil can be gauged by the production of crude oil (measured in millions of barrels per day), the amount of reserves of crude oil, specifically proved reserves (Figure 1.5), and the ratio of reserves to production (Figure 1.6), which gives an estimate of the number of years that the reserves can be expected to last. As expected, when the production of crude oil is high, prices are generally lower, although in general supply growth has tended to lag demand growth, leading to a gradually rising average price over the last two decades.

FIGURE 1.5 Distribution of oil reserves by region at the end of 2013; total proved reserves accounted for 1687.9 billion barrels

Source: BP Statistical Review of World Energy 2014.

FIGURE 1.6 Reserves-to-production (R/P) ratios by region at the end of 2013

Source: BP Statistical Review of World Energy 2014.

Long-term prices are affected by the amount of reserves remaining. Proved reserves of oil (also called “1P”) are those reserves that can be recovered in the future from known reservoirs with reasonable certainty (usually 90 % confidence) under present-day economic and operating conditions. Probable reserves correspond to a 50 % confidence level of recovery (called “2P” or proved plus probable), and possible reserves are those that have a less likely chance of being recovered (at least a 10 % chance) and are called “3P” (proved + probable + possible). Disclosures regarding reserves can be affected by local accounting rules and whether the company reporting the figures is private or public. Since a number of national oil companies are private, the reserve numbers reported by them do not have the same level of scrutiny.

Reserve growth predictions are also affected by developments in technology. For instance, prior to the large-scale commercialization of hydraulic fracturing (“fracking”) technology to exploit shale oil reserves and other technological innovations of the last decade, it was widely believed that oil would turn expensive. This was because oil production in the USA had peaked in the early 1970s (known as Hubbert's peak after M. King Hubbert, a US geologist) and the world's production was expected to peak in 1995. However, the introduction of new technologies and the increased viability of developing more difficult-to-extract reserves, such as oil sands, with higher prices of crude oil have combined to allow oil production to continue to grow.

In addition, in recent years there has been a discussion on reviewing the reserves of companies to account for “unburnable reserves” arising from the fact that it would be impossible to utilize some of the reserves if global warming targets are to be met. Similarly, carbon capture and storage (CCS) technologies would need to be developed before all the disclosed hydrocarbon reserves could be tapped. However, it is not yet clear if there is an appreciable impact of this concern on oil prices or the stock prices of energy companies.

Refining and Consumption

Refining capacity is an indicator of the maximum supply of oil products. Demand can be gauged from the consumption of crude oil and the consumption of individual refined products. Refinery throughput or capacity utilization is another measure of the demand for refined products. Data on imports and exports, as in Figure 1.7, can also provide clues about the geographical distribution of demand and supply as well as the energy security of individual countries or regions.

FIGURE 1.7 Oil production and consumption by region

Source: BP Statistical Review of World Energy 2014.

Trends in Economic Activity

The pace of economic activity is a good barometer of commodity consumption. An acceleration in GDP growth rate leads to higher usage of crude oil and other commodities, leading to higher prices during the uptrend in the economic cycle. Conversely, a contraction in economic output can lead to a sharp fall in commodity prices, as evidenced in the fall of 2008–09, when oil prices dropped from their highs of over 140$/bbl to lows of below 40$/bbl.

Technological Advances

Technological advances affect expectations of long-term supply and demand. For example, rising oil prices make it viable to develop more producing assets, thus increasing future reserves and production. However, rising oil prices also spur investment in alternative energy sources and shape future demand as well. For example, the development of hydroelectric, solar, wind, and other forms of energy generation, the growth in the usage of biofuels and compressed natural gas (CNG) for transportation, as well as heightened public awareness and demand for electric-powered vehicles and hybrids are all consequences of higher oil prices. The environmental impact of using oil can also be credited with the development of tougher standards on emissions, reducing energy intensity of new technologies, and increasing investments in alternative energy.

Short-Term Supply and Demand: Supply Chain and Infrastructure

Short-term supply and demand are affected by disruptions in the supply chain of the commodity. For example, the hurricanes Katrina and Rita led to a drop of over 1 million bbl/day in crude oil output from the Gulf of Mexico and refined product capacity was significantly reduced (by a third of national capacity at one point). Maintenance of oil rigs and other equipment can also lead to short-term price dislocations.

Upstream

Upstream production capacity and spare capacity affect prices as well. The amount of spare capacity maintained by OPEC, especially Saudi Arabia, has an effect on containing price rises. OPEC is an international organization, which aims to coordinate the petroleum policies of member countries and ensure the stabilization of oil markets. Its members, as of mid-2015, are the states of Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. OPEC accounts for over 81 % of the world's crude oil reserves as of 2012, and produces about a third of global production, thereby wielding significant influence over oil prices.

Refining

Prices of crude oil are also affected by their usability in refineries and refining capacity. As refineries are large installations, which are constructed over a long period of time, refining capacity is finite and inelastic and refineries are typically configured to handle a specific type of crude oil. Thus, price trends for crude oil will be affected by the refining capacity available to process that particular blend of oil. For example, if it is more profitable to refine heavy crude oil in a complex refinery (vs. light crude oil), complex refineries will run at full capacity, reducing the premium for light crude oil. The development of complex refineries in Asia has served to increase the value of heavy, sour crude oils such as Dubai and Saudi Arabian crudes.