Introduction

“Oil prices aren't just rising, but the volatility is also worsening-fluctuations are more pronounced than they were in the 1990s, creating unpredictable consequences."

These were the opening lines from the conference “Oil Price Volatility, Economic Impacts, and Financial Management: Risk-Management Experience, Best Practice, and Outlook”-Washington D.C. March 10, 2008.

Oil represents one of the most important macroeconomic factors in the world economy and the crude oil market is the largest commodity market in the world. What makes oil price changes even more interesting is not only their direct impact on economic activity, but also the changes in oil prices might reflect or even forecast changes in the intercontinental stability.

As a difference from other commodities oil is probably one of the few or the only production input that can affect both positively and negatively economic growth, to an extent that it might even lead to a recession. Oil price volatility dampens growth through different channels, from an increase in production cost to inflation expectations.

According to the Energy Information Administration (EIA) Global economic performance remains highly correlated with oil prices. Overall, an oil-price increase leads to a transfer of wealth from importing to exporting countries through a shift in the terms of trade. The magnitude of effect of a price increase depends on the contribution of the cost of oil in the national income, the degree of dependence on imported oil and the power of end-user to reduce their consumption and move away from oil.

According to Hamilton & Herrera (2003) inexpensive oil is crucial for the world's demand for energy but its availability is scarce, therefore volatility in supply will have substantial economic impact. That volatility in supply can be translated into “Peak oil”. With the ever growing demand of oil OPEC´s production capacity in the 2000´s was not enough to satisfy the world demand so the price of oil skyrocketed from 11$ a barrel in 1999 to all time high in history 147$ a barrel in august 2008.

About Crude Oil

Oil is long known and was chiefly used as a medicine and not as a fuel. Other common uses were dressing wounds and caulking boats. It was only by 1850s when the refining process was developed that oil started getting used as a fuel.

Earlier, black oil came out from natural springs in localities like Western Pennsylvania. No one knew how to extract. It was Edwin Drake, in 1859, who constructed the first make-shift oil derrick. The well was 70 ft deep and produced about 15 barrels per day. The area boomed quickly, and the modern oil industry was born. But its original uses of rock oil, according to a Yale chemistry professor's report at the time, could be refined and employed for illumination, lubrication, and other uses.

Crude oil is a naturally occurring, flammable liquid found in the rock formations of the earth. It consists of a complex mix of hydrocarbons of a range of molecular weights and other organic compounds. Under surface pressure and temperature conditions, lighter hydrocarbons (methane, ethane, propane and butane) occur as gases, while heavier ones (pentane and above) are in the form of liquids or solids. Crude oil varies greatly in look which depends on its composition. Typically it is black or dark brown (may be even greenish or yellowish).

Types of Crude oil

Crude oil can be classified on different parameters

A) Hydrocarbons :

According to nature of hydrocarbons they contain, crude oil roughly classified into three groups

a. Paraffin-Base Crude Oils :

This type of crude oils contains higher molecular weight Paraffin. Due to the high weight Paraffin are solid at normal room temperature. They also do not contain asphaltic (bituminous) matter. These crude oils are useful to produce high-grade lubricating oils.

b. Asphaltic-Base Crude Oils :

Under this type of crude oil we can find huge proportions of asphaltic matter with little or no Paraffin. Some of them are predominantly Naphthenes (cycloalkanes). Hence it produces lubricating oil which is more sensitive to temperature compare to paraffin-base crudes.

c. Mixed-Base Crude Oils :

The gray area between the above two types known as mixed-base crude oil. Both paraffins and naphthenes are found in this crude. Also some amount of aromatic hydrocarbons is mixed with them. Most crudes fit into this category.

B) Specific Gravity or API

In petroleum business the standard scientific measure of specific gravity is altered by a standard formula to yield American Petroleum Institute (API) gravity. API moves opposite to standard specific gravity, means the higher the API gravity, the lighter or less dense the crude oil.

a. Light Crude Oil:

Light crude oil is liquid petroleum. It has a low density and it flows freely at the room temperature. It has a low viscosity and specific gravity but high API gravity due to presence of a huge proportion of light hydrocarbon fractions. Generally it has low wax content. Light crude oil gets a higher price than heavy crude oil on commodity markets. This is because it produces a higher percentage of gasoline and diesel fuel when it is converted into products by an oil refinery. Crude oil having an API gravity more than 31.1 degrees is taken as light crude oil.

b. Heavy Crude Oil:

Heavy crude oil is a type of crude oil. It does not flow easily and is referred to as "heavy" because of its density or specific gravity which is higher than that of light crude oil. Activities like production, transportation and refining of heavy crude oil present huge challenges as compared to light crude oil. Crude oil of API gravity less than 21.5 degrees is considered as heavy crude oil.

c. Medium Crude Oil:

Crudes with a grade between 21.5 and 31.1 is known as medium crude oil.

C) Sulfur:

Crude oils contain certain amount of sulfur as an impurity. Crudes can be divided on the basis of percentage of sulfur content.

a. Sweet Crude Oil:

Petroleum is considered "sweet" if the content of sulfur is less than 0.5%. Sweet Crude oil contains little amounts of hydrogen sulfide with carbon dioxide. High quality crude oil is used for processing into gasoline. This is in great demand, particularly in the developed nations. Light sweet crude oil is the most demanded version of crude oil. It is termed sweet because of the low level of sulfur which provides it a mild sweet taste and pleasant smell.

b. Sour Crude Oil:

When the sulfur level in the oil is more than 0.5 % the oil is considered "sour". Impurities are removed before refining this lower quality crude into gasoline to increase the cost of processing. This produces a highly priced gasoline than the one made by sweet crude. This produces a highly priced gasoline than the one made by sweet crude.

Crude Oil Benchmark

Crude oil benchmarks are the reference points for various types of oil that are available in the market. These were introduced in the 1980s having the aim of setting a standard for the world's most actively-traded product.

WTI:

This is the benchmark for light sweet crude in the US. WTI crude oil has sulfur content of 0.24%. It has an API gravity of 39.6 and the specific gravity is 0.827. WTI crude is considered as high quality. The primary use is in the production of gasoline.

Brent Blend

: Light sweet crude found in the North Sea is taken under the Brent Blend oil marker. Its sulfur content is about 0.37, with an API of 38.06. It is good for producing gasoline.

Dubai Crude :

It is the crude oil benchmark for light sour crude obtained from the Persian Gulf. Its sulfur content is of 2% and the API is 31. It is used for pricing the crude which is0020exported to Asia.

Isthmus :

It is the crude oil benchmark for Mexican light crude. Its sulfur content is around 1.45% and the API gravity is 33.74.

OPEC Basket

It is the pricing data which is formed by collection of seven crude oils from the OPEC nations (except Mexico). OPEC introduced it on June 16, 2005. It is currently made up of the following: Saharan Blend (Algeria),  Iran Heavy (Islamic Republic of Iran), Girassol (Angola), Basra Light (Iraq), Kuwait Export (Kuwait), Es Sider (Libya), Oriente (Ecuador), Bonny Light (Nigeria), Arab Light (Saudi Arabia), Murban (UAE),Qatar Marine (Qatar), and Merey (Venezuela).

Oil Refining

Refining process depends on the separation of the crude into preferred and undesired components. The refining process is classified into three steps:

(1) Separation,

(2) Conversion,

(3) Chemical Treatment.

1. Separation:

It is the first stage of petroleum refining. It is able to divide the crude oil into some of its fractions but not all. Additional processes needs to be undertaken for further separation:

a. Solvent Extraction:

In this method chemical is added to dissolve the unwanted substances. Main solvents which are used are benzene, furfural and phenol. Quality of lubricating oils is improved by solvent extraction.

b. Fractional Distillation:

It uses the concept that dissimilar parts of the oil will boil at different temperatures. For e.g. petrol boils at around 24 degrees Celsius, but some other heavy oils have boiling points higher than 300 degrees Celsius. Refineries convert the desired fractions into vapour which is then siphoned from the base oil.

c. Crystallization:

It is mainly used to remove wax and other semi-solid substance from heavy fractions. Those fractions are cooled to a lower temperature. This causes them to solidify or form crystals. They are then put through a filter that separates them from solid particles.

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2. Conversion:

Petrol accounts for almost half of the petroleum products used in most countries. In order to improve the yield of desired products from petroleum, several methods have been developed. These methods aim to convert less useful fractions to more useful ones having more demand. These are categorized into two main groups:

a. Cracking Processes:

It converts the heavy fractions into the lighter ones, mainly petrol. These processes increase the quantity and quality of petrol obtained from oil.

b. Combining Processes:

It does the opposite process of cracking. Simple hydrocarbons are combined to make more complex fractions. Due to which many gases are produced and converted into fuels and valuable chemicals.

3. Chemical Treatment:

Almost every fraction is chemically treated before sending them to the consumers. The treatment method depends on the crude oil type and its end use. These treatments eliminate impurities like sulphur compounds that damage machinery and pollute air.

a. Hydrogen Treatment:

Hydrogen is generally used to remove impurities like sulphur compounds. Various fractions are mixed with hydrogen. It is then heated and exposed to a catalyst. Sulphur combines with the hydrogen to form hydrogen sulphide and is later removed using a solvent.

Major Products:

Petroleum products are usually grouped into three categories:

1. Light distillates

a. LPG

b. gasoline

c. naphtha

2. Middle distillates

a. kerosene

b. Jet aircraft fuels

c. diesel

3. Heavy distillates and residuum

a. heavy fuel oil

b. lubricating oils

c. wax & tar

Oil Demand and Supply History

Demand:

The introduction of the internal combustion engine (engine of cars) provided a demand for petroleum products that has sustained the industry to this day. Since then scientists discovered many different products from oil that are important many industries and manufacturers. Crude oil market is the largest commodity market in the world today. Throughout the eras of industrialization, in different parts of the world, demand for oil has always increased. In fact today it is seen as impossible to stop increasing demand. A first indicator of the economic growth is considered rapidly increasing oil demand or consumption.

The overall world crude oil demand grew an average of 1.76% per year from 1994 to

2005, with a high of 3.4% in 2003-2004 and is projected to increase 37% over 2008 levels by 2030 (118

million barrels per day from 86 million barrels), the largest part of increase in demand will come from the transportation sector.

Supply:

Supply of oil is crucial, when we look at its role everyday life. Petroleum usage in industries originated in Europe and USA. First oil wells were drilled in Europe, Russia and USA. However European countries were never big oil producers till hydrocarbon reserves were discovered in North Sea during the1970s.

Earlier kerosene was driver of the petroleum industry; however a big production need became apparent

after the Fords method of automobile production made it possible to buy cars for many ordinary people.

There have been three supply shocks in the recent history.

1979 Iranian revolution

:

Khomeini who is the religious leader came to power after protesters overthrew Shah, monarch of Iran. During that time Iran was producing 6 mb/d, which reduced to almost half.

1991 Gulf war and Soviet Union collapse:

Saddam Hussein invaded Kuwait. Big oil producers, created crisis of supply but for a shorter time than in previous one. Soviet Union was one of the biggest producers collapsed and so it too decreased supply.

The five biggest American companies created an oligopoly in union with the three European firms. Smaller companies also entered the market but they never competed the scope of the pioneer companies. The oligopoly made up legal and business systems for extracting oil and controlling supply. But the situation did not persist. Huge profits hindered the interests of reserve owner countries. This started to create a lot of agitation among people.

In response to the growing industry, the producing countries created Organization of Petroleum Exporting Countries (OPEC) to oppose them. Its aim was to change decision taking centers from west to the resource owner's territory. No real country or organization today effectively influences or controls supply as did “Seven Sisters”.

What explains historical oil price volatility?

Most experts say that increased crude oil markets and price volatility can be due to unanticipated economic developments. Chinese and Indian unforeseen heave energy demand and the declining weighted value of the U.S dollar can be recent examples. From the figure below it is obvious that first oil shock was the beginning of the era of the price instability that made world economic growth slower.

Main Factors behind Current Oil Prices

concerned about the effect of the scale of money being injected into the banking system of U.S. and the huge rise in fed govt. spending due to the economic stimulus bills.

Organization of Petroleum Exporting Countries (OPEC)

OPEC is a cartel of twelve countries made up of Algeria, Angola, Kuwait, Libya, Nigeria, Ecuador, Iran, Iraq, the United Arab Emirates, Saudi Arabia, Qatar and Venezuela. Principal goal of OPEC is to determine the best means for protecting the cartel's interests both individually and collectively. OPEC's decisions have had substantial influence on the international oil prices. For e.g. during the 1973 energy crisis OPEC refused to ship oil to the western countries that supported Israel in the Yom Kippur War, which was fought against Egypt and Syria. OPEC's decisions have had substantial influence on the international oil prices. For e.g. during the 1973 energy crisis OPEC refused to ship oil to the western countries that supported Israel in the Yom Kippur War, which was fought against Egypt and Syria.

OPEC's decisions have had substantial influence on the international oil prices. For e.g. during the 1973 energy crisis OPEC refused to ship oil to the western countries that supported Israel in the Yom Kippur War, which was fought against Egypt and Syria. This denial caused a four times hike in the oil prices, that lasted five months, starting October 17, 1973 and ending March 18, 1974. Evidence suggests that OPEC acted as a cartel while adopting output rationing in order to maintain price.

Global strategic petroleum reserves

Global strategic petroleum reserves ("GSPR") means the crude oil inventories that is held by the government of a particular country and private industry, for the purpose of providing economic and national security during an energy crisis. According to the United States Energy Information administration, approximately 4.1 billion barrels of oil are held in strategic reserves, of which 1.4 billion is government controlled. Presently the US Strategic Petroleum Reserve is one of the largest strategic reserves. Other non-IEA countries have begun to create their own strategic petroleum reserves where China is the largest of these new reserves. Current consumption levels are neighboring 0.1 billion barrels per day. It is suggested by some peak oil analyst that in the case of a dramatic worldwide drop in oil field output the strategic petroleum reserves may not last for more than a few months.

Russian Supply Factor

In 2007, Russian GDP grew nearly 8.1%, which made it the country's 7th consecutive year of economic expansion. The country's growth during the 2000-2007 periods was mainly caused by export of energy given a rise in Russian oil production and relatively higher world oil prices during this period. Russian economy is depends greatly on export of oil and natural gas. IMF and World Bank estimated that the oil and gas sector generated about 60% of Russian export revenues, and also accounted for about 30% of all FDIs in the country. About 70% crude oil from Russian production is exported, while the rest of 30% is refined locally.

Crude oil export through pipeline falls under the exclusive jurisdiction of Russian state-owned pipeline

monopoly, Trans neft. Fluctuations in oil price are a significant concern for Russian economy because it funded a major section of the economy in Russia. So as to cope with the price fluctuations, the govt in 2004 established a stabilization fund. By the end of 2007, the fund was expected to be worth $157.9 billion, or about 11.9% of the country's GDP.

With a rapid rise in the oil prices, Russia's economy flourishes initially. Yulia Tsep layeva, Merrill Lynch's chief economist, believes that per dollar increase in the oil price, Russian govt. earns about $1.69 billion a year. Long deteriorations in oil prices were followed by two remarkable periods of most intensive economic change in Russian history. Its fall from an 8% growth in 2008 to a 6.5% contraction in 2009 is considered as the most extreme of any major economy in the global slowdown.

Decrease in the prices of oil is bad for Russia. Main part of the country's GDP is received from exporting of crude oil and gas. Decreasing prices of oil may have several other severe consequences. For e.g.: a possible devaluation of the ruble, a severe drop in living standards.

The fall in oil price from $145 (2007) to less than $50 (2009) generated a large hole in the govt. budget calculations. Now it is facing a $149 billion shortage in its spending plans and by now is has cut the expenditures in 2009.

Crude oil from Russia is mainly sold to European and U.S. markets. Both these countries were hit severely by the recession, substitution and govt. taxation policies to reduce oil consumption. This led to Russian expansion of its production to the Asia-Pacific region, where energy demands are increasing rapidly. Even the nearness to big emerging economies such as Japan and China make crude oil from Russia prized for its quality and efficiency in trade to those growing markets.

Chinese Demand effect

China is the world's most populated country. It has a very rapidly growing economy. In 2008, China's real GDP is estimated about 9%. Most of the analysts predicted a growth of less than the target of 8% by govt. for 2009. Even then the 2nd quarter 2009 grew at 7.9% yearly.

In November 2008, China introduced a 3.9-trillion Yuan ($586 billion) of economic stimulus pack which is focused on boosting Chinese fixed asset investment and domestic consumption, in order to decrease its dependence on an export driven economy.

In 2008, China's real GDP is estimated about 9%. Most of the analysts predicted a growth of less than the target of 8% by govt. for 2009. Even then the 2nd quarter 2009 grew at 7.9% yearly.

Even during the economic slowdown in the past year, China's energy demand remained high. China has emerged from an oil exporter in the early 1990s to the world's 3rd largest oil importer in 2006.

Coal supported the majority (70%) of China's total energy consumption needs in 2006. Oil was the 2nd largest source (20%) of the country's total energy consumption.

In 2008, China consumed an estimated 7.8 mb/d of. This makes it the 2nd largest oil consumer in the world after the United States. In 2008, China's net oil imports were 3.9 million bbl/d, making it the 3rd largest net oil importer in the world after the United States and Japan. According to EIA forecasts Chinese oil consumption will grow during 2009-2010 and the oil demand will reach 8.2 million bbl/d by 2010.

The production situation has become less optimistic in Brazil, by contrast. Feedstock costs have risen

significantly as sugar prices soared past the 20 US cents/pound mark, driven by drought in India and

excess rain in Brazil's Centre-South. The high sugar prices incentivize sugar production versus ethanol

and the weather conditions will likely hurt overall sugar yields. IEA revised down our 2H09 production

estimate by only 5-10 kb/d with the start-up of new mills in July providing some offset. Still, production

risks lie to the downside given the combination of weather, sugar prices and the continued negative

impact of the credit crunch on production operations.

Refining Technology & Equipment: A very Important Role for Refiner's Future

The oil reserves known to the world are roughly 1.19 trillion barrels. Experts estimate that there is 4.59 trillion barrels of heavy oil reserves. Currently U.S. consumption rates predict that 10% to 15% of these oil reserves that are hard to refine would last about 70 years. Currently U.S. consumption rates predict that 10% to 15% of these oil reserves that are hard to refine would last about 70 years. With the declining volumes of light crude, oil companies such as Chev ron have started to invest in new refining technology that could convert oil with low hydrocarbon levels into light gasoline.

As the price of light crude rose to $146 per barrel during July 2008, many Oil Majors began invseting in technology caapable of producing and refining comparatively cheap heavy crude oil. With the rise in light crude's price, companies with con siderable cash on hand will be able to improve or modify their refineries to extract more precious, light refiend products. With the rise in light cr ude's price, com panies with considerable cash on hand will be able to improve or modify their refineries to extract more precious, light refined products. With the rise in light crude's price, companies with considerable cash on hand will be able to improve or modify their refineries to extract more precious, light refined products.

Conclusion

Short Term Prediction

The severe economic recession that spread worldwide in the past year severely affected the oil demand. Green shoots of economic recovery is clearly seen but the demand is not picking up accordingly.

However, despite the improvement of some economic indicators in few country, the most can be said is

that the global economy may be stabilizing - but even if this is confirmed, it remains far from evident that growth will resume strongly before the next year.

Crude oil prices are currently hovering around $60 to $70, bouncing back from a low of $34 in February.

Considering supply to be ample and demand as weak, the chances of oil going up is quite low. But those factors are over whelmed by a huge relief that it is not going be something like the Great Depression.

IEA holds the opinion that world oil demand would grow at a rate of 0.59%, or 540,000 bpd, annually over the period from 2008 to 2014, reaching 88.9 million barrels a day by 2014.

In the short term it seems to be fluctuating around $70 to $80, due to the strong demand from developing countries like India and China. Weak dollar also give support to the high oil prices. The upper limit will be kept in tab with the continuous supply from non OPEC countries like Russia.

Long Term Prediction

Though the short-term outlook for oil seems gloomy, the long-term viewpoint for crude is still strong, due to the weak point of the U.S. dollar and the chance that demand will ultimately return.

As estimated by IEA that oil demand will reinforce Saudi Arabia and India this year, in spite of a 3% decline in global consumption. China uses low commodity prices to stock up on resources. It plans to increase strategic crude oil reserves by 159% to 269 million barrels by next 5 years. Nikkei English News, in accordance to Chinese National Energy Administration, said that Beijing would spend $4.37 billion (29.94 billion Yuan) on stockpile services with an ability to hold 168 million barrels of crude oil. With the employment of expansive monetary policy by the U.S. Federal Reserve, the worth of the dollar seems certain to retest the lows it reached in 2008.

Due to the current improvement in economy oil could be around $119 by 2014. But an aggressive investment in development in alternate fuel can spoil things. The improvement in exploration technology would be interesting when the cost of production will become relatively low.

Source: Essay UK - http://turkiyegoz.com/free-essays/finance/crude-oil.php


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