EGEE 120
Oil: International Evolution

The Lecture for The Quest Chapter 8: The Demand Shock

PrintPrint

The Quest Chapter 8: The Demand Shock

Financialization

This lesson goes into some complex oil investment concepts, expands on the way that oil became more of a commodity. Some might find this to be a review, but all need to have an understanding of how they apply to the oil industry. These definitions add clarity to understanding how they apply to the oil industry.

Hedging

“Hedging is an investment technique designed to offset a potential loss on one investment by purchasing a second investment that you expect to perform in the opposite way. For example, you might sell short one stock, expecting its price to drop. At the same time, you might buy a call option on the same stock as insurance against a large increase in value.” - Farlex Financial Dictionary

Futures Contract

“An agreement to buy or sell an asset at a certain date at a certain price. That is, Investor A may make a contract with Farmer B in which A agrees to buy a certain number of bushels of B's corn at $15 per bushel. This contract must be honored whether the price of corn goes to $1 or $100 per bushel. Futures contracts can help reduce volatility in certain markets, but they contain the risks inherent to all speculative investing. These contracts may be sold on the secondary market, but the person holding the contract at its end must take delivery of the underlying asset. Futures contract are standard instruments; that is, unlike forward contracts, their provisions are standardized. As such, they may be traded on an exchange.” - Farlex Financial Dictionary

Inflation

The reduction in the purchasing power of a currency. Inflation has historically occurred when a country prints too much of its currency in too short a period of time. Central banks attempt to control inflation by raising interest rates when necessary, which decreases the amount of money in circulation. Inflation is inevitable whenever wealth is created, but central banks attempt to keep it between 2% and 3% whenever possible. - Farlex Financial Dictionary

Historically, the United States has led the oil industry, thus the price of oil has been tied to the US dollar. As the price of the dollar went down, the price of oil went up; enter inflation. This would be caused by the value of the dollar going down, but the value of oil remains consistent, so the price of oil would have to go up to accommodate this currency value change. Oil has a lasting long term value and can be used for stability for investment and ultimately gaining profit. Thus, investors can assume oil will maintain relative value over the long term. This makes it a good commodity to hedge higher risk investments. The demand for oil will continue to grow, as oil does not have a strong or consistent competitor through alternative energy options.  The power of the oil industry will continue until an economically viable alternative gains a significant market share.

If one oil company does all from wells to sale, they share cost & profit but if many companies are used, there are many spots for profit & loss.
Integrated oil company compared to when the process is separated 
Credit: Integrated oil company compared to when the process is separated by K. Jensen © Penn State is licensed under CC BY-NC-SA 4.0

The Quest goes into extended focus on the 1970s - 1980s oil trading beyond the daily trading. Going into the 1970s, oil companies were integrated following the example of Rockefeller as he built Standard Oil. Taking all the parts of the process under one large company allows for the company to absorb higher costs with higher profits along the process. The nationalization of oil companies in many oil-exporting countries contributed to the breakup and new approach to the flow of oil. The oil-exporting countries did not want the challenge of finding the individual consumer, but instead to pass on the risk to international oil companies who were already equipped with gas stations all over the world.

The separation of the process allowed for companies to sell off the higher risk areas and potentially make more profit, while allowing for new speculators to enter into the Wonderful World of Oil.

Yergin, Daniel. (2012). The Quest: Energy, Security, and the Remaking of the Modern World. New York: Penguin Books.