Crude oil (and petroleum) is often referred to as ‘black gold’, considering its high commercial value. It also has the potential to tip the scale of global economies.
Changes in crude oil prices impact its by-product prices. These include cooking oils, petrol/diesel, paints, tyres and transportation. Without oil and its by-products, sustaining the current economic order in the world is next to impossible.
Even a marginal increase in crude oil prices can trigger inflation, recession, or an energy crisis. It is because oil and gas is the backbone of global trade and play a crucial role in the development and prosperity of a country.
Let’s understand crude oil and the economy better.
With the onset of the Industrial Revolution post world war II, the US, Japan, and European countries became the biggest importers of oil and gas.
The OPEC imposed an oil embargo on exporting oil to the US in 1973. This was in retaliation to the West, supporting Israel and its military against Syria and Egypt during the Yom Kippur War.
OPEC’s move to halt oil exports to the US nearly crippled its economy. And oil prices rose nearly 350% in under 6 months, leading to a recession and inflation. Combined with economic stagnation, the event almost brought the US down to its knees.
When the world was recovering from the 1973 oil embargo, the political turmoil in Iran in 1979 led to a significant drop in oil production. With demand shooting up and production cut by 4%, crude oil prices soar. The Iran-Iraq war further aggravated the crisis before stabilising.
Saddam Hussein accused Kuwait of stealing its oil and set several Kuwaiti oil wells and reserves on fire. This resulted in a brief supply halt, with oil prices soaring.
The global economic order led by crude oil imports and exports is again threatened with Russia invading its neighbour Ukraine.
A member of OPEC+, Russia is the third-largest oil exporter after Saudi Arabia and UAE. The US has recently banned importing Russian oil and gas. The US receives nearly 3% of its oil and gas from Russia. Since the US dependence on Russia for oil is low, the US can afford to refuse Russian oil and gas. But European countries do not have the same luxury. Perhaps, that is why Europe has not put any bans on Russian oil.
The stand of European countries, especially Germany, remains hazy amid Russia’s intensifying offensive against Ukraine. German Chancellor Olaf Scholz clarified a few days ago that Germany could not afford to get its lights burned out in the face of war by stopping its import of Russian oil and gas.
Nevertheless, US President Joe Biden said that the US and its allies would release 60 million barrels of oil to counter the supply shortage due to sanctions and bans on Russia. However, it must be noted that the world consumes nearly 97 million barrels of oil in a day, and an additional 60 million barrels would hardly make a dent in the daily global demand.
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When one nation or a group of nations come together to impose sanctions on an oil-producing country, the direct impact would be on the oil supply. Thus, the oil price is on the rise due to a likely shortage of supply.
For example, when former US President Donald Trump imposed sanctions on Iran and abandoned the nuclear deal in April 2019, crude prices skyrocketed. Trump said that the move aimed to bring Iran’s oil exports to zero. This move threatened to wipe out nearly 1 million barrels of oil per day from the market amid weak supply. As a result, crude prices zoomed past the $75 per barrel mark for the first time in 2019. This says that hitting an oil-producing country with sanctions leads to soaring oil prices. It can also cripple countries that are reliant primarily on oil imports.
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Oil prices depend primarily on demand and supply, and geopolitical events significantly determine demand and supply.
By the simple rules of demand and supply, oil prices rise when demand is higher than supply. Conversely, the oil prices will go down when the supply is high, but the demand tanks.
In crisis-like situations like wars and geopolitical instability, the equilibrium between demand and supply suffers and destabilises global oil prices. Due to a range of political reasons, oil supplies could be stopped or reduced by some oil-producing countries.
While the members of the OPEC generally decide the supply, the U.S. has been the newest contributor to determining oil prices with its exports from oil shales. For instance, the oil prices in 2014 took a massive tumble after both OPEC and the US pumped out so much oil, which exceeded the global consumption threshold.
Similarly, demand also determines the pricing of crude oil. For example, the crude oil demand supply was hit in 2020 with pandemic-induced lockdowns worldwide. It severely reduced oil imports, bringing the oil prices to all-time lows.
In addition to this, the geopolitical tensions between OPEC members and Western countries determine the demand and supply. For example, the Gulf War of 1991 led to a significant fall in supply, thereby resulting in a price increase.
Members of the OPEC play an essential role in determining oil prices. The OPEC actively manages the oil production by its member countries and sets production targets for them. When OPEC cuts the production targets for its member countries, the supply in the international market reduces, which shoots the prices up. OPEC countries produce nearly 40% of the world’s total oil, and its exports represent over 60% of the total petroleum traded globally. The massive scale of this number makes OPEC a heavyweight in regulating the oil prices in the international market.
The formulation of a new OPEC+ with non-OPEC members makes countries like Russia and Indonesia also have a voice when it comes to regulating oil production.