How Oil Price are determined?
The concept of supply and demand is fairly straightforward. As demand increases (or supply decreases) the price should go up. As demand decreases (or supply increases) the price should go down. Sounds simple?
Not quite. The price of oil as we know it is actually set in the oil futures market. An oil futures contract is a binding agreement that gives one the right to purchase oil by the barrel at a predefined price on a predefined date in the future. Under a futures contract, both the buyer and the seller are obligated to fulfill their side of the transaction on the specified date.
The following are two types of futures traders:
Hedgers
Speculators
An example of a hedger would be an airline buying oil futures to guard against potential rising prices. An example of a speculator would be someone who is just guessing the price direction and has no intention of actually buying the product
The other key factor in determining oil prices is sentiment. The mere belief that oil demand will increase dramatically at some point in the future can result in a dramatic increase in oil prices in the present, as speculators and hedgers alike snap up oil futures contracts.
Production is high, but distribution and refinement aren’t keeping up with it.
The reason we're not awash in cheap oil is because those refineries operate at 90% of capacity.10 Ask a refiner, and they’ll tell you that excess capacity is there to meet future demand.
Then there's the problem of cartels. Probably the single biggest influencer of oil prices is OPEC, made up of 13 countries (Algeria, Angola, Congo, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Saudi Arabia, United Arab Emirates, and Venezuela); collectively, OPEC controls 40% of the world's supply of oil
OPEC could force prices to rise, and thereby theoretically enjoy greater profits than if its member countries had each sold on the world market at the going rate.
The Bottom Line
Unlike most products, oil prices are not determined entirely by supply, demand and market sentiment toward the physical product. Rather, supply, demand and sentiment toward oil futures contracts, which are traded heavily by speculators, play a dominant role in price determination. Cyclical trends in the commodities market may also play a role.
Why India cannot cheer oil price fall wholeheartedly this time ?
NEW DELHI: The windfall gains associated with a massive decline in global crude oil prices may not materialise this time for India in entirety.
Brent futures dropped to $36 per barrel in early deals on Monday, falling nearly 30% in a single session. Brent had traded around $50 per barrel a month ago.
If these levels sustain, it would surely reduce the import bill of India and therefore the current account deficit by a big margin.
By extension, it would also reduce pressure on India’s headline retail inflation. This is good news for the Reserve Bank of India (RBI) as it hasn’t been able to cut policy rates due to the expected rise in retail inflation. Now it could get more motivation to slash rates in the coming policy meet.
But that is all the good there is to the oil price fall.
To start off, in earlier episodes of oil price fall, the government had a windfall gain through lower subsidy outgo as the fuel subsidy bill was hefty. That meant that fiscal deficit could be curtailed. However, this time around there has not much subsidy given to oil companies to begin with. For FY20, the government estimates subsidies at ₹38,568 crore and for FY21 it is budgeted at ₹40,915 crore.
“There is unlikely to be a net positive effect on the fisc from the oil prices fall, if this sustains. There are several offsetting factors involved," said A. Prasanna, economist at ICICI Securities Primary Dealership Ltd.
Of course, the government has the option to increase excise duty on petroleum, Prasanna argued, citing that this has been done in the past. That would mean additional revenue.
But these are times when the economy going through a slowdown and demand conditions have been subdued. To impose taxes on fuel would be risky. But even if the government taxes fuel to get boost revenue, state-owned oil producers are bound to get hit by the price fall globally. That would mean depressed earnings and lower dividends. Already refining companies have been facing margin pressure due to subdued demand.
The earnings of not just companies but Indians employed abroad too could see an impact. Middle East countries that are predominantly oil-based economies are at a serious risk from the sharp fall in crude. These countries account for more than half of remittances to India. To be sure Opec has in the past resorted to production cuts to arrest the fall in oil prices and could do so again. Even then the impact on the economic growth of these countries cannot be ignored. That said, the impact on remittances could be lagged, economists said.
Indian consumers won’t necessarily pay less for petrol or diesel because of the sharp fall in benchmark US crude prices on Monday, said an industry executive.
For one, the cost of the Indian basket of crude, which is the average of Oman, Dubai and Brent crude, was $20.56 a barrel on 17 April. This is nearly $10 lower than the March price of $35 a barrel, which the government took as an opportunity to raise the excise duty on petrol and diesel by ₹3 each.
Though consumers should be benefiting from the fall in international oil prices, the price build of petrol and diesel is such that it does not translate to retail fuel prices.
“Retail prices of petrol and diesel in India are linked to the prices of these fuels in global markets, not to that of crude oil per se. So, only when these product prices come off, will we see some impact on pump prices in India. Besides, with our tax component still high, consumers may not get the desired relief," said the executive at an oil marketing company on condition of anonymity.
In fact, for consumers to benefit from the drop in international crude and product prices, state-run fuel retailers Indian Oil Corp. Ltd, Bharat Petroleum Corp. Ltd and Hindustan Petroleum Corp. Ltd had switched to daily price revision from a fortnightly pricing system in June 2018 as the government sought to further pricing reforms in the sector. Crude oil fetched $46.96 a barrel then.
“The Indian economy is a major winner from lower world oil prices,” Rajiv Biswas, Asia Pacific chief economist at IHS Markit, told CNBC, pointing out that more than 80% of India’s total energy consumption in the 2018-2019 financial year was imported. He explained that falling energy prices could reduce India’s inflation and lower the cost of its import bill — that could, in turn, help narrow the country’s trade and current account deficits.
Biswas added that sharply lower oil and gas costs would also help boost profitability for sectors that are intensive users of petroleum — such as petrochemicals, power generation, and transportation.
Softening of inflationary pressure on the economy could also give the Reserve Bank of India more room to cut interest rates further in an attempt to help stimulate growth and improve the flow of money in India’s financial markets, he said.
For every dollar the price of oil drops, India saves approximately $1.5 billion, according to Akhil Bery, an analyst at political risk consultancy Eurasia Group. “However that is offset by the weaker rupee, so the benefits may not be as much as originally anticipated,” he told CNBC. In the last 12 months, the rupee weakened against the greenback from levels near 70 to around 74 and oil prices are usually measured in U.S. dollars.
“It will help alleviate some of the fiscal pressures that the government has been under,” Bery added.
Experts pointed that whatever benefits India may potentially get from lower oil prices could be wiped out if there is a sudden, rapid coronavirus outbreak within the country, similar to what happened in places like Italy, Iran and South Korea.
Extract From
Economic Times, Investopedia * Livemint
The concept of supply and demand is fairly straightforward. As demand increases (or supply decreases) the price should go up. As demand decreases (or supply increases) the price should go down. Sounds simple?
Not quite. The price of oil as we know it is actually set in the oil futures market. An oil futures contract is a binding agreement that gives one the right to purchase oil by the barrel at a predefined price on a predefined date in the future. Under a futures contract, both the buyer and the seller are obligated to fulfill their side of the transaction on the specified date.
The following are two types of futures traders:
Hedgers
Speculators
An example of a hedger would be an airline buying oil futures to guard against potential rising prices. An example of a speculator would be someone who is just guessing the price direction and has no intention of actually buying the product
The other key factor in determining oil prices is sentiment. The mere belief that oil demand will increase dramatically at some point in the future can result in a dramatic increase in oil prices in the present, as speculators and hedgers alike snap up oil futures contracts.
Production is high, but distribution and refinement aren’t keeping up with it.
The reason we're not awash in cheap oil is because those refineries operate at 90% of capacity.10 Ask a refiner, and they’ll tell you that excess capacity is there to meet future demand.
Then there's the problem of cartels. Probably the single biggest influencer of oil prices is OPEC, made up of 13 countries (Algeria, Angola, Congo, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Saudi Arabia, United Arab Emirates, and Venezuela); collectively, OPEC controls 40% of the world's supply of oil
OPEC could force prices to rise, and thereby theoretically enjoy greater profits than if its member countries had each sold on the world market at the going rate.
The Bottom Line
Unlike most products, oil prices are not determined entirely by supply, demand and market sentiment toward the physical product. Rather, supply, demand and sentiment toward oil futures contracts, which are traded heavily by speculators, play a dominant role in price determination. Cyclical trends in the commodities market may also play a role.
Why India cannot cheer oil price fall wholeheartedly this time ?
NEW DELHI: The windfall gains associated with a massive decline in global crude oil prices may not materialise this time for India in entirety.
Brent futures dropped to $36 per barrel in early deals on Monday, falling nearly 30% in a single session. Brent had traded around $50 per barrel a month ago.
If these levels sustain, it would surely reduce the import bill of India and therefore the current account deficit by a big margin.
By extension, it would also reduce pressure on India’s headline retail inflation. This is good news for the Reserve Bank of India (RBI) as it hasn’t been able to cut policy rates due to the expected rise in retail inflation. Now it could get more motivation to slash rates in the coming policy meet.
But that is all the good there is to the oil price fall.
To start off, in earlier episodes of oil price fall, the government had a windfall gain through lower subsidy outgo as the fuel subsidy bill was hefty. That meant that fiscal deficit could be curtailed. However, this time around there has not much subsidy given to oil companies to begin with. For FY20, the government estimates subsidies at ₹38,568 crore and for FY21 it is budgeted at ₹40,915 crore.
“There is unlikely to be a net positive effect on the fisc from the oil prices fall, if this sustains. There are several offsetting factors involved," said A. Prasanna, economist at ICICI Securities Primary Dealership Ltd.
Of course, the government has the option to increase excise duty on petroleum, Prasanna argued, citing that this has been done in the past. That would mean additional revenue.
But these are times when the economy going through a slowdown and demand conditions have been subdued. To impose taxes on fuel would be risky. But even if the government taxes fuel to get boost revenue, state-owned oil producers are bound to get hit by the price fall globally. That would mean depressed earnings and lower dividends. Already refining companies have been facing margin pressure due to subdued demand.
The earnings of not just companies but Indians employed abroad too could see an impact. Middle East countries that are predominantly oil-based economies are at a serious risk from the sharp fall in crude. These countries account for more than half of remittances to India. To be sure Opec has in the past resorted to production cuts to arrest the fall in oil prices and could do so again. Even then the impact on the economic growth of these countries cannot be ignored. That said, the impact on remittances could be lagged, economists said.
Indian consumers won’t necessarily pay less for petrol or diesel because of the sharp fall in benchmark US crude prices on Monday, said an industry executive.
For one, the cost of the Indian basket of crude, which is the average of Oman, Dubai and Brent crude, was $20.56 a barrel on 17 April. This is nearly $10 lower than the March price of $35 a barrel, which the government took as an opportunity to raise the excise duty on petrol and diesel by ₹3 each.
Though consumers should be benefiting from the fall in international oil prices, the price build of petrol and diesel is such that it does not translate to retail fuel prices.
“Retail prices of petrol and diesel in India are linked to the prices of these fuels in global markets, not to that of crude oil per se. So, only when these product prices come off, will we see some impact on pump prices in India. Besides, with our tax component still high, consumers may not get the desired relief," said the executive at an oil marketing company on condition of anonymity.
In fact, for consumers to benefit from the drop in international crude and product prices, state-run fuel retailers Indian Oil Corp. Ltd, Bharat Petroleum Corp. Ltd and Hindustan Petroleum Corp. Ltd had switched to daily price revision from a fortnightly pricing system in June 2018 as the government sought to further pricing reforms in the sector. Crude oil fetched $46.96 a barrel then.
“The Indian economy is a major winner from lower world oil prices,” Rajiv Biswas, Asia Pacific chief economist at IHS Markit, told CNBC, pointing out that more than 80% of India’s total energy consumption in the 2018-2019 financial year was imported. He explained that falling energy prices could reduce India’s inflation and lower the cost of its import bill — that could, in turn, help narrow the country’s trade and current account deficits.
Biswas added that sharply lower oil and gas costs would also help boost profitability for sectors that are intensive users of petroleum — such as petrochemicals, power generation, and transportation.
Softening of inflationary pressure on the economy could also give the Reserve Bank of India more room to cut interest rates further in an attempt to help stimulate growth and improve the flow of money in India’s financial markets, he said.
For every dollar the price of oil drops, India saves approximately $1.5 billion, according to Akhil Bery, an analyst at political risk consultancy Eurasia Group. “However that is offset by the weaker rupee, so the benefits may not be as much as originally anticipated,” he told CNBC. In the last 12 months, the rupee weakened against the greenback from levels near 70 to around 74 and oil prices are usually measured in U.S. dollars.
“It will help alleviate some of the fiscal pressures that the government has been under,” Bery added.
Experts pointed that whatever benefits India may potentially get from lower oil prices could be wiped out if there is a sudden, rapid coronavirus outbreak within the country, similar to what happened in places like Italy, Iran and South Korea.
Extract From
Economic Times, Investopedia * Livemint