Mentor’s Comment:

The intro will talk about the uneven nature of resource distribution on earth. Establish the relation between input prices and economic development. Generally link the price of a resource with its abundance. Give examples. Then talk about oil. Highlight its importance in economic development and talk about the current price spike. Stress on role of India’s import dependence.

But, also talk about the secondary factors that influence oil prices – eg. geopolitics, geoeconomics, transportation and distributions infra etc.

Model answer

What determines oil prices?

• With oil’s stature as a high-demand global commodity comes the possibility that major fluctuations in price can have a significant economic impact. The two primary factors that impact the price of oil are: supply & demand; and market sentiment.
• The concept of supply and demand is fairly straightforward. As demand increases (or supply decreases) the price should go up. As demand decreases (or supply increases) the price should go down. But the price of oil as we know it is actually set in the oil futures market.
• An oil futures contract is a binding agreement that gives one the right to purchase oil by the barrel at a predefined price on a predefined date in the future. Under a futures contract, both the buyer and the seller are obligated to fulfill their side of the transaction on the specified date.
• The other key factor in determining oil prices is sentiment. The mere belief that oil demand will increase dramatically at some point in the future can result in a dramatic increase in oil prices in the present as speculators and hedgers alike snap up oil futures contracts. Of course, the opposite is also true.
• The mere belief that oil demand will decrease at some point in the future can result in a dramatic decrease in prices in the present as oil futures contracts are sold (possibly sold short as well), which means that prices can hinge on little more than market psychology at times.

What is OPEC?

• The Organization of the Petroleum Exporting Countries (OPEC) is a permanent, intergovernmental Organization, created at the Baghdad Conference on September 10–14, 1960, by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela which were later joined by eight other Members.
• OPEC’s objective is to co-ordinate and unify petroleum policies among Member Countries, in order to secure fair and stable prices for petroleum producers; an efficient, economic and regular supply of petroleum to consuming nations; and a fair return on capital to those investing in the industry.

How much influence does OPEC have on global oil prices?

• The OPEC has significant influence on the price of oil.
• If OPEC countries are unsatisfied with the price of oil, it is in their interests to cut the supply of oil so prices rise.
• However, no individual country actually wants to reduce supply, as this would mean reduced revenues.
• Ideally, they want the price of oil to rise while they raise revenues.
• This issue often arises as OPEC pledges to cut supply, causing an immediate spike in the price of oil. Over time, the price moves lower when supply is not meaningfully cut.
• One case where OPEC’s expectations would be altered is when its share of world oil production declines, with new production coming from outside nations such as the U.S. and Canada.

Conclusion:

• The political and economy movement in any region can impact the world oil price. Particularly, in unordinary situation e.g. major war, the price is quite volatile. The news about the major oil producers and users in the world especially in the Middle East, North Sea and the USA, etc predominantly impacts oil market more than the news about other regions.
• Therefore, monitoring unrest political situation, strike, coup d’etat, assassination of political leaders of OPEC countries or the decision of international organization which influences international politics, is thus critical. These news all affect the price adjustment due to the concern and worry despite the fact the production and export volume still remain unchanged.