In the article Oil Prices: What's Behind the Volatility? Simple Economics, Kraus (2016) noted that the oil sector has been in its lowest point from the 1990s. The firms that made record profits over the recent past now have low earnings notwithstanding the presence of perfect competition. This has forced them to adopt strategies that would help them maintaining a competitive edge over the other firms in the industry. For instance, it is noted that some firms are reducing investment in exploration and areas of production. Others have gone bankrupt with about 250,000 workers in the US losing their jobs on an annual basis. The main reason for this according to Kraus (2016) is the plunging oil barrel price that fell more than 70% at one time in comparison to the levels seen in June 2014. In the last year, prices recovered on different occasions. Most of the wells are not profitable despite the fact that the industry has been able to reduce costs. Moreover, most of the shale wells found in Texas which were profitable in the past at price levels beyond $60 a barrel are currently profitable at levels beyond $40. This is an increase in the rig count. However, executives believe that it will take time before oil goes back to $90 or $100 a barrel as it was in the past. This was the price that characterized the previous years. The question that begs is why the price of oil dropped in the first place when oil is in such a high demand. Does it have anything to do with the market structure?
Everything is based on the law of supply and demand as explained in the economics, microeconomics to be particular. Kraus (2016) noted that domestic production in the US has almost doubled over the past years. This has forced out oil imports which must find another home. Oils from Algeria, Saudi Arabia and Nigeria which once sold in the US are now competing for Asian markets. Producers are compelled to drop prices. There is consistent rise in oil production and exports from Canada and Iraq. Moreover, Russians with their economic problems notwithstanding have been able to maintain pumping. Despite this, there are signs that there could be decline in production due to reduction in exploration investments. In Venezuela which is characterized by political instability, production is fast declining. On the other hand, attacks from rebel groups in Nigeria have reduced suppliers in the area. Yet constant fighting in Libya has impeded efforts to revive the countrys oil sector. However, according to Kraus (2016), these fluctuations could be short-lived and this points to a different argument.
This is the fact that volatility in the prices of oil is largely attributed to the changes in demand contrary to Hamiltons (2003) emphasis on supply.In the same vein, Kraus (2016) submitted that from the context of demand, the European economies and those of developing nations are weak. In addition, vehicles are fast becoming energy efficient. As a result, there is a lag in fuel demand, though there are signs showing that demand is increasing in China and the US.With the expansion of the global economy, the demand for oil increases. This is attributed to the fact that oil is a basic ingredient in this dispensation. It is therefore not surprising that the real price of oil, with everything else constant, relies on the state of the global economy.
Despite this, the role played by flow demand for the actual oil price was never acknowledged for a long period of time. It is Barsky and Kilian (2002) who first presented demand as a primary determinant of the real oil price. They used indirect evidence to demonstrate that the major fluctuations in the prices of oil during the 1970s and 80s seem largely linked to fluctuations occurring in the global business cycle. Today, researchers can directly quantify the significance of demand for the change in the prices of oil. In answering the question posed by Kraus (2016) as regards the reason for the change in oil prices in the first place and to drive the point home, Killian (2009) noted that most of the constant fluctuations in the prices of oil from 1970s have been linked to the cumulative impacts of oil demand as opposed to the supply shocks. This corroborates the findings of Barsky and Kilian (2002). The methodological approach introduced by these researchers has been overhauled over the years. However, the content of the finding has not changed.
In summary, this article and other studies have established that much as supply is a major factor in explaining oil fluctuations, there is overwhelming evidence pointing to the fact that oil demand shocks justify fluctuations in oil prices over the years. In this regard, a major role is attributed to flow demand shocks. It is therefore incumbent upon all stakeholders to ensure that these concerns are addressed in order to restore stability in the oil industry and protect consumers from constant price fluctuations.
The concept of perfect competition is used in the first paragraph and it means a situation in the market where there are numerous buyers and sellers who are well informed, eliminating all aspects of monopoly and the market price of a product cannot be controlled by individual buyers and sellers.
Market structure is another concept used in the first paragraph implying collection of factors that determine the manner in which buyers and sellers interact in a market, change in prices and how various production levels and processes of selling interact.
The law of supply and demand is used in paragraph one. It is the theory describing the effect that the availability of a specific product and the desire for that product has on the price.
Volatility is used in the third paragraph and it means the level of variation of a trading price series through a period of time as determined by the standard deviation of returns.
Barsky, R&Kilian, L. (2002). Do we really know that oil caused the great stagflation? A
Monetary Alternative. In: Bernanke B, Rogoff K (Eds), NBER Macroeconomics Annual 2001: 137-183
Hamilton, J& Herrera, A. (2004). Oil shocks and aggregate economic behavior: the role of
monetary policy. Journal of Money, Credit and Banking36: 265-286
Kilian, L&Park, C. (2009). the impact of oil price shocks on the U.S. stock market.
International Economic Review 50: 1267-1287
Kraus, C. (2016). Oil prices: what's behind the volatility? Simple economics.The New York
Times2 Nov. 2016. Retrieved from http://www.nytimes.com/interactive/2016/business/energy-environment/oil-prices.html
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