By: Luky Yusgiantoro, Ph.D.

Economic analysis is the cornerstone of most important decisions made by major energy stakeholders. The major component in conducting economic analysis is the price, which indicates the value of transaction conducted by consumer and supplier in a market at a particular time. However, the difficulty when studying the price is the inability of people to furnish the variables to properly predict the future price. Energy prices are reflected by oil prices because of the oil dominancy meeting the global energy consumption. In 2015, with the production of over 90 million barrel per day, the world is still relying heavily on oil as it contributes 32% of the global energy consumption. The dominance of oil usage usually leads to the indexation to other energy prices, such as natural gas prices. There have been many academic studies that investigate the correlation of different oil prices with other variables. Furthermore, oil prices can be analyzed from different perspectives, such as from the history of oil prices, the OPEC vs. Market prices, short and long-term prices, the different type of oil prices.

Nevertheless, the basic understanding of oil prices and their volatilities is vital for parties participating in oil industries. The volatility of oil prices in the last few years has caused alarm to energy stakeholder as they steeply went down to below $30/barrel in early 2016. Currently, the oil price is hovering between $40/barrel and $50/barrel but expected to keep going down because of global over-supply of oil. In the past, oil prices are less volatile and predictable because of the limited number of global oil producers; hence producers are the price setter. The evolution of the global market and the existence of economic profit on the market conveys to the entrance of new oil players and the financial innovation to capture the rent of oil prices.

These days, even with the existence of OPEC, the global oil market can be considered as a competitive market. Therefore, oil producers and consumer are now price taker, and fluctuation of oil prices is simply caused by the changing of oil supply and demand. Oil producers want high prices and oil consumers want low prices. When attempting to analyze the behavior of oil prices, the price elasticity of oil supply and demand matters. Price is elasticity reflects the percentage of change in quantity demanded or supplied caused by one percent change in prices. The oil demand and supply are impacted by different factors, and they may be a difference depending on the time length of the analysis.

In the short term, there are perceptions that the geopolitics and macroeconomic realms directly influence the oil prices. However, those aspects basically are embedded in the supply and demand of oil in the market. For example, a conflict between two countries leads to a shock on oil demand or a shock on oil supply, which trigger a fluctuation in oil prices. Normally, looking from the demand side, the short-term price elasticity for oil demand is low because the inability of oil consumers and producers to opt different energy resources in a certain period. However, in the long run, the impact of the low cost of oil substitutes, such as gas, coal and renewable energy, compels oil to be at the edge the competitiveness and lead to the possible low oil prices. Moreover, in the long run, the technology impacts the supply side by reducing or increasing the cost of finding and producing oil.

Ultimately, oil prices signal the global oil market condition as it indicates the scarcity of global oil resources to meet global oil demand and the capital allocation in the oil sector. Also, oil prices reflect the confidence and foresight of stakeholders to be in the future oil market. The volatility of oil prices remains unpredictable. This leads to uncertainty on when the equilibrium will occur and at what price. Therefore, there is still much academic work and research needed to learn the behavior of oil prices and, essentially, to predict the trend of future oil prices.

*This opinion piece is the author’s own and does not necessarily represent PYC.

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