Over the past weeks, the oil market has been in a state of panic following the tensions between the United States (U.S) and Iran involving the killing of an Iranian general and retaliatory attacks on U.S military bases in Iraq – with Iraq recently being drawn into the confrontation. In response, the U.S urged all Americans to leave Iraq, while analysts have also hinted on possible missile attacks on oil installations in Saudi Arabia as well as heightened risks to oil tankers in the Persian Gulf.
Granted, these are dangerous times for the crude oil market as oil prices tend to be sensitive to geopolitical tensions! But times have changed, and the global oil market is not the same as it was in 1990 or early 2000’s.
This research article therefore presents an overview of the global oil market in the past 30 years (between 1989 and 2019) and shows how market players have changed; focusing specifically on global supply & demand, WTI -Brent Crude spread and a potentially disruptive yuan contract as key market players. We then conclude by highlighting the major challenges facing the market in this present time.
Crude oil is a global commodity and its value is driven by fundamental factors of supply and demand.
Consequently, oil supply has grown since the 1990’s with non-OPEC crude oil production brewing in the past few years and OPEC essentially maintaining its role as a swing producer to stabilize the market. According to IEA data (Fig1), between 1989 (just before the start of the Gulf war) and 2018 (the year preceding the Persian Gulf crisis), world oil production increased by 45%. Within the same period, OPEC production soared by 61%, OECD production (largely dominated by the USA and Canada) grew by 44%, and production from the rest of the world shot up by 30%.
More recently, between 2017 and 2018, OECD production went up by about 1.6%, while OPEC and production from the rest of the world plunged by 1.1% and 0.6% respectively. Led by the recent shale boom, the U.S oil production has driven most of the OECD and global production growth in the past 2 years, ahead of Saudi Arabia, Russia, Canada and Iraq.
On the demand side, global oil demand between 1989 and 2017 grew by about 47% according to the 2018 OPEC annual report (Fig 2A). This growth was largely led by Asia & the pacific regions with most of it coming from China. Quite notable is the fact that within the same period, oil demand in other world regions remained somewhat flat.
Beginning in the late 1980’s up until 1992, oil demand showed positve growth across most of the regions, except in Eastern Europe & Eurasia and in North America. By 1992, however, North America’s demand started to grow again, although not able to keep up with the fast paced Asian & pacific growth, and in 2003 finally gave up the chase. Since then, the Asia & pacific region has shown significant growths in demand – closely mimicking the total world oil demand growth pattern. In fact, comparing the demand by region (fig 2A) to total demand (fig 2B), we can see that the Asia & pacific region largely drives world oil demand.
In 2018, however, the global economy began to shrink which was further aggravated by a trade war between the United States and China, that also slowed oil demand growth.
According to the world bank data (Fig 3), global growth for 2018 fell by 3% from the previous year, and for 2019 it recorded an estimated growth deceleration of 2.4% – the lowest since the 2008 global financial crisis.
WTI-Brent crude Spread
The WTI is the benchmark for North American crude oil while the Brent Crude is the benchmark for European, African, and Middle Eastern crude oil. Although, there are other benchmark oils, the WTI and Brent Crude provide an easy way to value crude oil based on quality and location.
Beginning in 1989 and until 2010, WTI was priced above Brent crude (except in 2008). However, owing to the dynamic nature of oil supply and demand, the benchmark prices have been continually changing. In 2010, Brent crude became more expensive than WTI and has kept up this lead till date (Fig 4).
Between 1989 and 2010, the largest/smallest spread was in 2004 ($3.25) and 2007 ($0.10) respectively. In the period that Brent crude became more expensive, the largest spread was in 2012 ($17.58) while the smallest was in 2010 ($0.13). Overall, and considering the period from 1989 to 2019, the largest/smallest spread was in 2012 ($17.58) and 2007 respectively ($0.10).
Several factors influence this spread. For a long time WTI was priced higher (being of better quality than Brent Crude – It is sweeter, although Brent Crude is considered slightly lighter) and the spread in the period from 1989 to 2009 averaged around $1.48. However, between 2010 and 2015, the US crude oil transportation and refining bottlenecks that followed the dawn of a new shale production era (amidst export restriction) prompted a decrease in WTI prices and reversed the spread. In 2011, fears over the closure of the Suez Canal caused Brent crude to rise. In the same year, Iran threatened to close the straits of Hormuz through which 20% of the world’s daily crude oil flowed and as expected, the spread widened even further. Extreme geopolitical tensions between countries can also influence the spread. For instance, war tensions between U.S and Iran and even the presence of U.S troops in the middle east can result in panic buying (purchasing bizarrely large quantities of crude oil in anticipation of a perceived disaster) causing a rise in crude oil storage and shortage of exports into the market. Since Brent crude is the price benchmark for the Middle Eastern crude oil, such a scenario has the potential of strengthening the price of Brent and thus widening the spread. On the flip side, a regional war could also lead to reduced demand, which would put pressure on oil prices.
“Oil is priced in dollars” is an expression that has flooded the oil business for decades now, but is this going to change with China and its growing influence on the world crude oil market?
Historically, in 1974, Saudi Arabia and the United States (being the largest oil consumer at the time) signed an agreement committing the Saudis to transact only in dollars for all its crude oil sales – and was later extended to all of the members of the Organization of Petroleum Exporting Countries (OPEC). This gave rise to the petrodollar system, which offered the U.S. the huge advantage of being able to use its dollars to purchase oil.
However, things began to change in 2018. Being the world’s largest importer of oil since 2017, and its consumption expected to surpass that of U.S by 2030, it became pertinent for China to strengthen its position and have a bigger say in the global pricing system. Based on this, China officially launched (in March 2018) the yuan crude oil futures contracts which, unlike WTI and Brent, is dominated in the Chinese national currency (yuan) and is traded on the Shanghai International Energy Exchange (INE). Its specification is shown below:
Table 1: Specifications of the yuan contract
|Product||Medium sour crude oil|
|Quantity||1000 barrels per lot|
|Price Quote||Yuan per barrel|
|Tick Size||0.1 yuan per barrel|
In addition to being the largest importer of crude oil (Fig 5), the U.S Energy Information Administration (EIA) has also predicted that by 2030 China will replace the United states as the world’s largest oil consumer. This means that it can potentially exert some leverage over Saudi Arabia in the future to pay for crude oil in Yuan (a repeat of history)
To guarantee China’s futures delivery, China has constructed many crude oil bonded depots (for seven medium sour crudes) located on the coastline where oil tankers can discharge their cargo, which are principal transit points for oil companies in the North East Asia region. It has also witnessed a dramatic opening of its oil sector, particularly with regards to oil trading. Independent refiners now have direct access to imported crude unlike previously when crude import business was restricted to the state-owned firms.
How did it thrive after its launch?
Following the launch of the yuan-dominated oil futures trading on the INE, the Chinese currency’s presence in the oil market has been reinforced. Transactions doubled over the period from June to December last year and have already overtaken those of the rival Dubai Mercantile Exchange (DME). In fact, also notable in December of the same period was that trading volumes on the exchange came close to the Brent (Fig 6).
On August 07, 2018, the yuan oil futures contract spiked to a record high, coinciding with the re-imposition of US sanctions on Iran. The spike marked the biggest daily move in China’s oil futures since its inception in March of the same year.
Following the re-imposed sanctions on Iran, the U.S put pressure on companies and governments around the world to fall in line. But as Iran’s biggest customer and at a time of its dispute with the U.S (trade war), China reportedly ignored the U.S demands (to choke off Iran’s oil exports which represents its main source of income). In this way, there is a potential for China to shift some of the trading activities away from the dollar and into its yuan. Similarly, given Russia’s disputes with the U.S, Russia could also be interested in selling oil to China in the yuan.
In this way, the emergence of a potentially disruptive yuan contract has been one of the major changes in the oil market in the period considered in our study.
In conclusion, the Impact of war tensions today will not be as severe as it was in the 90’s and early 2000’s. The reason is simply the oversupply of crude oil in today’s market. However, the slowed demand growth and rising popularity of the Yuan contract remain key challenges for the global energy market and particularly for the U.S, especially in a time of rising geopolitical tensions.
EIA: “China Surpassed the United States as the world’s largest crude oil importer in 2017”, February 2018, https://www.eia.gov/todayinenergy/detail.php?id=34812
FRED: “Crude Oil Prices: Brent -Europe”, March 2020, https://fred.stlouisfed.org/series/DCOILBRENTEU
FRED: “Crude Oil Prices: West Texas Intermediate (WTI) – Cushing, Oklahoma”, March 2020, https://fred.stlouisfed.org/series/DCOILWTICO
IEA: “Oil Information 2019 – A comprehensive reference on current development in oil supply and demand”, August 2019, https://www.iea.org/reports/oil-information-2019
The Balance: “Understanding the Crude Oil Market – pricing Differential Between Brent Crude and WTI”, March 2020, https://www.thebalance.com/crude-oil-brent-versus-wti-808872
The World Bank: “Global Economic Prospects – Slow Growth, Policy Challenges”, January 2020, https://www.worldbank.org/en/publication/global-economic-prospects
Investopedia: “Benchmark Oils: Brent Crude, WTI and Dubai”, January 2020,https://www.investopedia.com/articles/investing/102314/understanding-benchmark-oils-brent-blend-wti-and-dubai.asp