Tuesday, July 26, 2016

Why the Price of Oil Will Not Rise?

The price of oil after reaching nearly $50 per barrel in mid 2016 is rapidly descending to a level below $40 per barrel. The pundits explain this as a problem of Supply and Demand. Supply and Demand is the catchall phrase popular among followers of Keynesian Economics, but it is a superficial explanation. Supply and Demand does not incorporate the thousands of factors that compose the market system. Supply and Demand does not recognize the importance of the two actors in every purchase and sale decision. In every transaction there is a buyer and seller. There is only a completed transaction if the buyer is happy with the offered price and the seller is happy with the given price. Each party has the option of refusing the price offered. The strength of the negotiators will determine the direction of prices not Supply and Demand.

Certainly, the competitive environment can affect the negotiating position of one party over another. The seller will find it difficult to negotiate a high price when other suppliers offer lower prices, but that is not Supply and Demand. That is competition. There is competition, because other suppliers have product they want to sell. Oil sellers would be wise to recognize this competitive environment instead of just throwing up their hands in disgust, they should develop strategies to deal with their competitors. Most products on planet earth exist in a competitive environment. Oil is not unique.

Why is the oil industry so handicapped? One reason is the oil industry origins are not as entrepreneurial as most industries. The oil industry grew out of a monopoly environment where there was no competition. Second, today most of the largest oil companies are government owned, and so vital to their country's economy that they must sell under any conditions. This requirement makes negotiation impossible. This is where much of the world's oil industry finds itself. This situation is not hopeless. It requires creativity, a characteristic not often found in the oil industry.

What can the oil industry do to level the negotiating field? First, leave the field. The industry should seek to find more niche markets to sell in. Instead of the large customers getting price breaks divide the sellers up into smaller segments and sell directly to them at the higher prices they pay to their suppliers. Second go down the supply chain and provide more refined products. Instead of just selling crude oil look at selling partially processed oil that allows smaller and more specialized refiners to buy. This increases the competition for the product and raises prices.

Just one more example. The best strategy for sellers is to refuse to sell at low prices, but how is that possible in the oil industry? One way is to use a financial option to fund the holding costs of the product. Simply leave the oil in the  ground and sell an option to deliver it at a set price (higher than the current market price) one year from today or two years from today. Obviously, these options can not be written for more oil than purchaser's are demanding so it requires some wise constraint.

One last thought, before I move on to another topic. Countries should consider establishing oil banks, storage facilities that serve as security for national currencies. I would certainly prefer having my currency backed by oil rather than a promise to pay or gold. After all, oil is black gold.