Lesson 6: Energy – focus on oil

In yesterday’s lesson you learnt more about some of the properties of gold, how the precious metal is used by investors to hedge against a loss of purchasing power in paper currencies and the risk of geopolitical events.

Today’s lesson takes a detailed look at one of the other major commodities – the oil market.

Oil is a vital in powering the global economy, from power generation to transport and finally industry. Since oil and its derivatives are so important to industrialised economies, a large and sharp increase in its price will probably lead to higher prices for most products, raising overall inflation and reducing economic productivity.

Since the 1970s, almost every spike in the price of oil has been followed, relatively rapidly, by a recession in the Western world.

Different economies and sectors within them face different exposures to oil prices. Net oil exporting countries benefit from higher oil prices, while net importing countries such as India lose out. Within an economy airlines and car manufacturers may be adversely affected by a rise in the cost of oil, while oil services companies will benefit.

OPEC

The Organisation of Petroleum Exporting Countries (OPEC) was set up in Baghdad, Iraq, in September 1960, to co-ordinate opposition to cuts in posted prices by the multinational oil companies. OPEC is a group of countries including some of the largest oil producers in the world.

As of mid-2018, OPEC included Algeria, Angola, Congo, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, the United Arab Emirates, Saudi Arabia and Venezuela.

OPEC’s overall objective is to achieve as high an oil price as possible, satisfying the interests of its members, but without snuffing out global demand for oil. OPEC generally looks to manage the oil price through formal or informal production quotas for each individual OPEC member. These quotas are determined by an individual producer’s stated oil reserves.

Each OPEC member must be able to trust the other OPEC members in order to stick to the agreement. If not, and if one producer starts producing more than their allocation then OPEC as a whole will produce more oil than they agreed to, pushing down oil prices and making all other members worse off.

Saudi Arabia, being the largest producer, has traditionally held the role of “swing producer” within OPEC. A commodity supplier in this position tends to possess significant spare production capacity and is able to adjust commodity supply at minimal additional cost in order to help balance the market and adjust prices.

Geopolitics

Given its importance to the running of the modern global economy, nation states frequently battle for control over oil.

A cursory look at a simple oil price chart dating back to the 1970s reveals a series of bumps. Each of these can be pinpointed to wars and conflicts, whether it was the Iranian revolution, the Iraqi invasion of Kuwait or the US-led invasion of Iraq.

More recently, Arab Spring-related uprisings in Libya and elsewhere have resulted in escalating geopolitical tensions across many important energy production and transit countries.

Industrialised countries have sought to protect themselves from a sudden loss of supply by holding strategic reserves. One of the most well-known strategic reserves is the US’ Strategic Petroleum Reserve, the largest emergency supply in the world.

Energy forms the backbone of modern industrial economies, and energy resources are critical export commodities for those who possess a lot of them. As long as fossil fuels remain the dominant source of energy, oil supply and oil prices in particular will remain critically important.

A renewable electric future

The growth of renewable energy may usurp oil’s importance. Whether it’s solar, wind or hydropower a decline in costs may reduce oils use in power generation. Meanwhile, increased use of electric vehicles will reduce oil demand from the transportation sector.

The oil market has never been stable, and probably never will be.

I hope you found this lesson on the role that oil plays in the modern global economy and why it is so strategically important.

In the next lesson we focus in more detail on one of the main agricultural markets – soybeans.

Go to lesson 7