Market

Although many factors have contributed to higher crude oil prices, a combination of strong (and somewhat unexpected) global demand for oil since 2003 and expectations of continuing future tightness is the major cause. These demand/supply imbalances reflect robust global activity, an apparent shift in the demand for oil by China and other emerging economies, and limited investment in the oil sector in the past two decades. Naturally, given the tightness in the oil market and uncertainties about demand and supply, factors such as geopolitical developments, fears of potential supply disruptions, and speculation have also all played a part in price movements, but largely through their impact on expectations regarding future fundamentals. Refinery bottlenecks have put additional pressures on petroleum product prices—as demonstrated by the significant rise in gasoline prices following the 10 percent reduction in U.S. refinery capacity caused by Hurricane Katrina.

On the supply side, the main players in the crude oil market are OPEC—which currently provides about 40 percent of world supply and holds about 70 percent of proven reserves—and non-OPEC producers. OPEC, as the marginal supplier, behaves as a semi-cartel in normal times by aiming to maintain excess extraction capacity in order to influence crude oil prices. In recent years, its policy has been to balance the market while allowing for an ‘appropriate’ level of crude oil inventories in consuming nations. Non-OPEC producers, excluding Russia, on the other hand, have relatively limited reserves and spare capacity, and generally behave as price takers.

Key players in the energy markets span a diverse group of commercial and non-commercial investors. The set of so-called commercial traders—traditionally oil producers and energy companies that tend to hedge—has been expanded by the growing number of investment banks and hedge funds who own energy-producing facilities, and the emergence of specialized energy trading firms in the wake of deregulation. Furthermore, the distinction between commercial and non-commercial traders is increasingly blurred as non-commercial traders may enter into swap arrangements in which commercial traders act as their agent.

This result likely reflects the fact that crude oil prices are determined in a global market, one that interacts with localized, relatively competitive product markets. Shocks in local product markets may not affect local product prices immediately, unless of course product inventories are insufficient—as in the aftermath of Hurricane Katrina. In general, crude oil prices respond, depending on global supply conditions, only after the shocks in individual product markets accumulate to become a large shock for the global crude oil market. Local product prices will eventually reflect crude oil price movements, but obviously with a lag.

Market fundamentals, together with expectations of continued tightness, have been the primary influence on crude oil prices during the past two years.

The functioning of the crude oil market could be enhanced and excessive upward pressures on prices reduced by better and more timely data collection, more efficient taxation, improved investment environment, and energy conservation.