The product that I have chosen is Oil. Oil is a natural product that is found in oil wells in large quantities. The nature of oil found in these wells is crude and it has to pass through several refining processes, before the final product is obtained. Crude oil is used to create Jet Fuels, Motor Lubes, Petrol, Diesel, and other important products that are used by both the household consumers, as well as the industrial consumers. According to Economicsonline (2014), the use of Oil by the industrial organizations dates back to 18th century.
Source: Infomine, 2014
The graph above shows the trend of crude oil prices. They have risen in the last five years by around 100%. The oil was trading in mid $40s in the year 2009. The current price of Oil is around $78. This shows an increase of oil by 100%. However, one must also remember that the price of Oil has significantly come down from what it was during 2011. There was a boom in the Oil prices in 2011 because of an artificial shortage created by OPEC. However, the situation has been corrected, and Oil shows an approximate increase of 20% annually.
Many industries use oil as their raw material, whereas others use oil to manufacture chemicals for the production process. In any case, we see that oil is probably the most important product in the global markets right now. There are also conspiracy theories, that many of the current future wars will be fought for this product. Whatever happens remain to be seen, but one thing is for sure, that Oil is the most important product in the history of mankind. It is used in almost all industries, and has become a household products with the introduction of automobiles, and other oil-operated equipment.
The map below shows the oil production in different parts of the world. It can be seen that Oil is mainly produced by the Middle Eastern and Asian countries. The major production of oil comes from Saudi Arabia, Iraq, Kuwait and Libya. Russia also produces large quantities of Oil and is second only to Saudi Arabia. America and Latin American economies also produce large quantities of Oil. Brazil and Venezuela are top oil producers in the region. It is also surprising that a large amount of Oil reserves have been found in Norway. This shows that the production of oil comes from diverse regions around the world. This means that the nature has provided us with the ample supply of oil. However, one must also remember that Oil prices are most volatile in the world. They keep on changing on daily basis. As a result, many companies dealing in oil choose to buy contract and hedge the price decline risk.
Source: (Mapsofworld, 2014)
The production Oil market is 85 Million barrels of crude oil per day. This oil is then transported to the refineries where the oil is refined and impurities are removed, and making it fit for the use in the industries, machineries, chemical manufacturing, rubber manufacturing, and in automobiles. The extraction of Oil requires specialist machinery and personnel. As a result, premium price and wages are paid to the workers who specialize in this field.
The structure of market is such that some companies have full integrated chain of extracting the crude oil, refining it, and then selling it through its own retail network. The supply of the total oil extracted and produced is controlled by an organization known as OPEC. The organization consists of majority of countries that produce oil. The purpose of the organization is to limit the supply of oil in order to complete its prices high. In other words, a cartel, or colluding oligopoly has been created using this organization in order to make sure that the oil producing countries keep earning high returns on their oil production and manufacturing. This is a sad case, that such organization is being allowed to run by the modern economists, as it creates artificial shortage when the prices are falling, and raises price unnecessarily whenever they want to. Another sad fact about the industry is that 95% of the oil trading is done on paper using derivatives and future contract. This leads to an artificial increase in the demand and leads to higher price. Only a proportion of the oil is used, produced and sold in the form of physical delivery. This leads to an inflated demand figures, and hence the price of oil is always more than what it should be. (Platts, 2010)
Supply conditions in the market are very strong. There has been an increase in the number of companies producing and exporting oil. However, the formation of OPEC and other cartel have restricted the supply of oil in order to raise prices. There are several kinds of crude oil that is being used all over the world. Among the famous ones are WTI, Brent, and SaudiLite. The supply of oil is always kept at levels that are lower than the actual demand of oil. This is done to give an artificial hike to the oil price. Since, prices are high, the margin of the oil producers rises, and they earn abnormal or supernormal profits (OPEC, 2014)
Oil is a non differentiated product. As a result, it can be classified as an oligopoly. Another important point of the industry is that it faces a kinked demand curve. As a result, the producers in the industry find it better to collude with each other in order to increase their collective profits rather than competing with each other in terms of price. This formation of Oligopoly means that the final consumer ends up paying more for the product, and the producer ends up earning a supernormal profit. Even these supernormal profits cannot be reduced to normal profits in the short-run because Oil is a natural product. No one can produce Oil on its, and hence it is very difficult for new competitors to enter the industry unless it has large amount of capital and technology at its disposal to the oil wells, and then invest in the land for drilling of oil. The industry is guarded by these factors, and as a result, the current producers are enjoying great rate of return on their investment.
The OPEC consists of around 12 full members, and 5-10 observers. This means that there are 17-20 countries in total that are producing oil. These nations have chose to remain closely linked for their benefit, and are exploiting the non-oil producing countries. This is a sad fact, that a natural resource is being deliberately under supplied for the sake of higher profitability at the expense of non-oil producing countries.
The OPEC and other oil producing companies have an agreement among themselves to increase their collective profits through the establishment of a cartel and operating like an oligopoly. This results in the bulk of wealth changing hands from oil consuming nations to oil producing nations. The total value of this wealth is around billions of dollars which are being earned by OPEC and other oil producing nation as a result of their unfair pricing policies.
Oil is being sold in future contract at either fixed price of floating price. For example, in January a refinery may purchase 60,000 barrels of oil at $80. The deal has been locked, and even if the prices the refinery will have to pay only $80 per barrel at the time of delivery. However, if the prices fall the refinery will suffer a loss. In order to eliminate this risk, now days the contract are being negotiated at a floating rate. The deal price is the current spot price of the day. However, some companies are reluctant to use spot price to save them from price risks. Saudi Arabian Companies refuse to trade oil in spot prices.
The final Oil price is being calculated by taking into account the spot price of the crude oil. In addition, the refiner margin is added to the spot price of the crude oil. After that there is a distributor or retailer margin that is added to come to the final price. All of this is very tricky as the price of crude oil changes frequently and therefore new quote is required for the refined oil. Sometime when the future contract are being traded, the price is determined by adding a further charge of holding cost, and going interest rate in the market to arrive the price of future contract. In both case, it is normally assumed that under perfect market conditions and upward sloping yield curve, the future price of oil are going to be more than the spot price. (Investopedia, 2009)
The biggest barrier to entry in the industry is the fact that Oil is a natural product. It cannot be produced, or its supply cannot be increased overnight. The wells get exhausted, and hence there is a limited supply of Oil. Also the quality and quantity of Oil differs from one region to another, and hence this is biggest barrier to entry in the Oil market. No company or country can produce Oil on its own unless it has resources and pieces of land where the Oil reserves are found.
Recently, many companies and countries have taken an initiative of introducing new technology in the market. This has increased the yield of Oil, and the number of barrels of Oil that is produced each day is increasing. However, this technology is really expensive and cannot be used by small, and financially weak groups.
The governments around the world are more focused on finding Oil reserves these days then they were ever before. This is due to the fact that Oil prices have increased a lot during the last decade or so. Many non-oil producing nations have experienced rapid decline in their reserves, and a burden on their current account balance. Therefore, a lot of countries are trying to find their own oil reserves. (IMF, 2014)
The use of oil is mostly in the industry, chemical manufacturing, rubber production, and it is used by the household for their cars or automobiles. However, the bulk of demand comes from the derivatives and option holders. This constitutes to the 95% demand from Oil. Oil prices generally rise when there is an increase in demand of oil. For example, during the last few years oil price rose due to massive increase in the second hand vehicles trading that increased the demand for tyres. Since, tyres are produced from rubbers, an increase the demand for rubber, increased the demand for Oil and as a result prices of Oil shot up.
Oil is a necessity these days. As a result the price elasticity of demand is very low. Everybody needs to buy oil for travelling. Industries need to produce the demand of their own customers, and hence the demand of Oil does not change with the prices. This is another reason why OPEC manipulates the prices of Oil. It knows that it is a necessity and will be bought at any price. As a result, it raises the prices of Oil to increase its revenue. (McKinnon, 2014)
The demand for Oil is likely to increase in the coming years with the increase in number of vehicles being produced by the companies worldwide. The demand of Oil is also going to rise because of the industrialization and increase in the population. Oil is needed for almost every machine, chemical preparation, and production of some it’s essential by-products such as dyes, and rubber. The market for Oil in the coming future is going to go up because of the massive increase in the number of vehicles that are being used by the people around the world. Similarly, the world’s population is rising at a very fast rate. Since Oil is needed in all aspects of life, there is going to be an increase in the demand of oil in the coming years. There is also move towards more and more people trading on derivatives, and contract markets. This again is going to raise the demand of Oil and in turn its prices are also going to shoot up.
References
Imf.org,. 2014. 'The Structure Of The Oil Market And Causes Of High Prices'. https://www.imf.org/external/np/pp/eng/2005/092105o.htm.
InfoMine,. 2014. '5 Year Crude Oil Prices And Price Charts'. http://www.infomine.com/investment/metal-prices/crude-oil/5-year/.
Investopedia,. 2009. 'ISLM Model Definition | Investopedia'. http://www.investopedia.com/terms/i/islmmodel.asp.
Mapsofworld.com,. 2014. 'World Crude Oil Producing Countries Map'. http://www.mapsofworld.com/minerals/world-crude-oil-producers.html.
McKinnon, Judy. 2014. 'Honda To Invest About $750 Million In Ontario Plant'. WSJ. http://online.wsj.com/articles/honda-to-invest-about-750-million-in-ontario-plant-1415293523.
Opec.org,. 2014. 'OPEC : Member Countries'. http://www.opec.org/opec_web/en/about_us/25.htm.
Platts,. 2010. 'The Structure Of Global Oil Markets'. http://www.platts.com/IM.Platts.Content/InsightAnalysis/IndustrySolutionPapers/oilmarkets.pdf.
