Where to Go in Oil Prices
Oil prices have declined by more than $15 over the last three months and have dipped slightly below $100. The recent movement in oil prices is good news for countries that are largely dependent on imported oil whereas countries that mostly rely on oil revenues are concerned whether this decline in prices will continue. It seems that the factors that affect the oil prices in the short-run and in the long-run are quite different and therefore we need take into account these differences when making projections about the future movements in oil prices.
In the short-run news about demand and supply dynamics are largely speculated in the market and oil prices are significantly affected from this speculation. We should look at the recent price movements in that way and make our forecasts based on that. When northern Iraq city of Mosul was seized by ISIS at the beginning of June, markets started to make a speculation that this might create a cut in oil supply and prices have increased by more than 5% in two weeks’ time. Later it was seen that developments in Iraq did not give a harm to oil production and prices started to decline. 
Investors who have taken a position by expecting an increase in prices probably closed their positions and this has played a significant role in the recent decline in oil prices. Another important factor that could explain the recent movement in prices is the euro/dollar exchange rate. One can easily see that over the last three months there emerged a very high correlation (0.84) between euro/dollar exchange rate and oil prices. It seems that in the short-run oil prices will continue to be affected from the developments in euro/dollar exchange rate. European Central Bank has recently reduced the interest rates and has announced that they will buy more asset backed securities. Accompanied by a slow economic growth in European Union, this means that the downward pressure on Euro might continue for the next couple of months and this might reflect itself as a decline in oil prices. The slowdown in global economic growth and news related with this might also be speculated in the market and this may also lead to a decline in prices in the short-run.
Although developments in financial markets are very important in understanding and predicting oil prices in the short-run, market fundamentals, that is demand and supply, play a bigger role in affecting oil prices in the long-run. In Asia-Pacific which accounts for one third of the total oil consumption in the world demand has significantly slowed down in 2013. While in 2011 and 2012 the whole increase in world’s total consumption has come from Asia-Pacific, in 2013 this ratio has declined to 34%. On the other hand in North America which is the second largest consumer in the world, oil demand which has been declining since 2010, has shown a large increase in 2013. In Europe the economic recovery is still very slow and demand stays stagnant. In Middle East demand has been steadily increasing as it is in Asia-Pacific. However as the share of this region in total consumption is only 9.2% the increase in oil demand has a limited impact in prices. In the long-run it seems that there will not be a rapid economic growth in Asia-Pacific as it was the case over the last decade. Besides that many developing countries are facing lower economic growth rates. Therefore, we will probably not see huge increases in oil demand for the next couple of years.
On the supply side we need to watch the developments about two very important countries for oil markets. These are Iran and Iraq. The total proved reserves of Iraq and Iran is around 307 billion barrels and this number is more than three times the reserves that Russia owns. However, when we look at the actual production the total oil supply of Iran and Iraq is only 62% of Russian supply. These numbers reveal that Iraq and Iran has a huge potential in terms of meeting the future increase in oil demand. If the embargoes on Iran are loosened and the political stability is achieved in Iraq they can easily produce up to 7-8 million barrels per day. Especially Iraq could reach these levels in a very short period of time. These developments on the supply side might put a downward pressure in oil prices in the long-run.
Both the short-run and long-run dynamics reveal that the downward trend in oil prices might continue for a while. However, we should take into account that fossil fuels, particularly oil and natural gas, will continue to be a major source of energy for the world and large price declines will not be possible.
Note: “The views expressed in this blog are the author's own and do not necessarily reflect the Institute's editorial policy.”
This article originally appeared on Hazar Strateji Enstitusu