Economic Cycles, Price Movements and the

Disconnect between Demand and Supply:

The case of Crude Petroleum

Santhosh T Varghese 1

Introduction

Economic cycles are characteristic features of capitalist economies. The

advent of neo-liberal paradigm of economic development and the consequent
hell-bent stampede for embracing globalisation in the economic plane rendered
economies, even having substantial level of state presence in economic activity,
vulnerable to the innate cyclical movements of market economies, within
no time.

The macro economic model of aggregate supply and aggregate demand

considers exogenous changes in aggregate supply and aggregate demand are the
forces that cause fluctuations in the economy as a whole (Mankiv, 2002).
Exogenous changes in aggregate supply and aggregate demand curves are often
called as supply/demand shocks and these shocks. The real business cycle models
are also sometimes referred as models driven by aggregate “supply shocks”.

But Plosser (1989) agues that such a description nevertheless seems

approximately accurate for models driven by productivity shifts, it is potentially
misleading, as there is nothing inherent in the real business model that limits it
to the analysis of variations in technology or supply. Hence ‘supply shocks’ in the

1
Lecturer, Post Graduate Dept. of Economics, PM Government College, Chalakudy,
Affiliated to Calicut University, Kerala, India. Visit at: http://www.santhoshtv.in
Blogs at: http://www.alwayseconomics.blogspot.com, and
http://www.facts-unmasked.blogspot.com

1
model of aggregate supply and aggregate demand alone are referred as ‘price
shocks’.

Price shocks alter the cost of producing goods and services and the prices
that firms charge. The oft cited example of price shock/supply shock is the crude
oil price shock which results in an upward revision of cost of production and
prices across-the-board, especially in a developing economy. Such shocks disrupt
economic well being by pushing output and employment away from their natural
rates and causes fluctuations in the economy. In theory, the government can
make use of the tools of stabilisation policy to dampen these fluctuations but the
priorities and concerns of the government, especially in a neo-liberal
environment, largely determines the nature and character of tools of the
stabilisation policy and, by and large, it may end in protecting the interests of
capital and market.

As such, the interests of the general public and the unempowered need to
be protected and for that, special efforts are to be taken to uncover the ‘obscure
factors’ that largely propel the price movements of crude petroleum. This
assumes significance as public offices sympathetic to market forces more often
than not shirk in exposing these ‘obscure factors’ but religiously diligent in
shielding them under the cover of ‘impact of economic/oil fundamentals’. Hence,
it becomes imperative to examine; the role of ‘supply shocks termed as price
shocks’ and the extent of influence of ‘economic/oil fundamentals’ upon the price
movements of crude petroleum. If other factors, which are hypothesised as
obscure factors, are found prominent in exerting undue influence they must be
skinny dipped and their relationship with the neo-liberal economic environment
is to be accentuated. To abridge, fortifying the general public and the poor from
the capricious movements of crude oil prices needs a methodical and
comprehensive appreciation of price movements especially in a neo-liberal
regime.

2
 It is in context, the study attempts to dissect the price movements in
crude oil to comprehend the reasons for the apparent disconnect between
demand-supply balance and the factors behind price formation and its
consequent impact upon the economic well being of the nation. The paper is
divided into six sections. The first section delineates certain features of the
present economic cycle, the second one highlights the role of crude oil prices in
the overall make-up of wholesale price indices and its impact upon poverty, the
third section analyses the behaviour of demand, supply and prices of crude oil,
the fourth one sequesters the disconnect between oil ‘fundamentals’ and oil
prices, the fifth section examines the role of futures trading and the elements of
speculation and the last section furnishes the concluding remarks.

The Boom and Bust in the Sub-Prime Era

Economists are yet to advance cogent theoretical explanations for the
economic boom of 2001-2008 and the consequent continuing meltdown in
economic activity. Nonetheless, it is well accepted that, the sub-prime lending,
speculative movements of finance capital, low regulatory measures in financial
sector and the heavily shrouded financial transactions and the latest argument
regarding the role of US current account deficit, etc—all undoubtedly contributed
to the present cycle in economic activity.

Dissecting the economic cycle in the aggregate economy by considering the

behaviour of all constituent time series, wide opens interesting and revealing
scenes regarding the behaviour of conflicting movements among different time
series. Bober (1971) clearly punctuated that an expansion or contraction phase
does not mean that all time series in the economy are moving in tandem or in
same direction, ie, upward in an expansion phase and downward in a contraction
phase. He rightly pointed out that, for instance, “….once the peak is turned, the
proportion of falling series edge clearly into majority and go on to become a
greater and greater majority as contraction continues…” (Bober 1971, pp41).

3
 The economic cycle of the sub-prime era also conforms to this conclusion
and conflicting movements in time series are observed. The various time series
related to crude petroleum exhibits conflicting movements compared to the
aggregate behaviour. This needs to be explored further. Moreover, economic
variables related to crude petroleum are crucial variables especially for a
developing economy as the price of petroleum products have a cascading effect
on prices across-the-board and adversely affect the budget line of vulnerable
sections of the economy. Besides, adverse fluctuations in petroleum product
prices fuel inflation and result in the northward movement of poverty ratios.

Crude Oil Prices, WPI and Poverty

The wholesale price index (WPI) of India for the period 2002-03 to
2008-09 is analysed to understand the influence of fluctuations in crude
petroleum prices. Even though, the fuel, power, light and lubricant commodity
group have only a 14.23 weight in the wholesale price index (WPI) of India,
during 2008-09, inflation rate of this commodity group (12.9%) is higher than
that of the overall inflation rate (10.3%) and is also the highest among different
commodity groups (See Table 1 given below).

4
 Table: 1 Wholesale Price Indices

All Commodities/ Weight 2002- 2003- 2004- 2005- 2006- 2007- 2008-
Major Groups (%) 03 04 05 06 07 08 09*

All Commodities
100.00 166.8 175.9 187.3 195.6 206.2 215.8 236.6
(WPI)
Inflation Rate (%) 3.4 5.5 6.5 4.4 5.4 4.7 10. 3
Primary Articles
(WPI) 22.02 174.0 181.5 188.1 193.6 208.7 224.7 222.8
Inflation Rate (%) 3.3 4.3 3.7 2.9 7.8 7.7 8.2
Fuel, Power,
Light & 364.4
Lubricants (WPI) 14.23 239.2 254.5 281.0 306.8 324.0 327.0
Inflation Rate (%) 5.5 6.4 10.0 9.2 5.6 1.0 12. 9
Manufactured
Products
(WPI) 63.75 148.1 156.5 166.3 171.4 179.0 187.9 204.6
Inflation Rate (%) 2.7 5.6 6.2 3.1 4.4 5.0 9.9
N.B.:Yearly WPI is based on average of weekly indices

* April-November 2008-09 (Provisional)

Source: GOI (2009b)

A more detailed picture is displayed by the table given below which gives
the time series of monthly WPI for selected groups and commodities for the
period from January 2007 to February 2009.

5
 Table: 2 Time Series of Wholesale Price Indices of Selected groups

Feb- Jan- Dec- Nov- Aug- Jun- May- Apr- Mar- Feb-
Oct-08 Sep-08 Jul-08
09 09 08 08 08 08 08 08 08 08

All
227.78 229.58 229.75 234.18 239.03 241.5 241.24 240 237.38 231.08 228.5 225.54 219.88
Commodities
(I) Primary
247.93 249.08 247.33 250.94 251.45 252.2 249.28 248.68 243.95 241.94 238.63 235.86 230.55
Articles
(II) Fuel,
Power, Light
323.5 328.56 331 348 369.15 375.3 377.94 377.2 374.43 346.96 342.85 341.52 335.25
& Lubricants

(II.B)
378.35 388.44 393.65 427.6 470.65 483.23 488.56 487 481.4 425.58 417.08 414.58 405.15
Mineral Oils
(III)
Manufactured 199.43 200.74 201.08 203 205.73 207.95 207.94 206.35 204.5 201.5 199.48 196.1 190.43
Products

Jan- Dec- Nov- Oct- Sep- Aug- Jun- May- Apr- Mar- Feb-
Jul-07 Jan-07
08 07 07 07 07 07 07 07 07 07 07

All
218.15 216.42 215.88 215.18 215.06 213.78 213.63 212.28 212.28 211.5 209.76 208.88 208.83
Commodities
(I) Primary
224.58 222.5 223.88 223.85 225.98 223.75 224.5 220.6 220.93 219.18 214.64 214.95 214.23
Articles
(II) Fuel,
Power, Light
334.5 331.7 327.1 323.7 321.86 322.35 321.85 321.98 322.05 320.35 319.84 319.8 322.05
& Lubricants

(II.B)
403.5 400.06 393.7 386.9 383.08 384.03 383 383.3 383.45 380.3 379.14 378.63 381.8
Mineral Oils
(III)
Manufactured 189.95 188.58 188.28 187.98 187.46 186.08 185.73 184.88 184.83 184.55 183.52 182 181.7
Products

Source: GOI (2009a)

6
 The data in the table is plotted in the adjoined graph to better understand
the behaviour of the time series. A clear cyclical movement in the WPI of mineral
oils is quite evident from May 2008 onwards where it peaked in August 2008.

Figure: 1 Series of Wholesale Price Indices

All Commodities Primary Fuel group Mineral Oils Manufactured Products

500

450

400

350

300

250

200

150
A u g -0 7

A u g -0 8
Ju n -0 7

Ju n -0 8
Ju l-0 7

Ju l-0 8
Ja n -0 7

A p r-0 7
M a y -0 7

N o v -0 7
D e c -0 7
Ja n -0 8

A p r-0 8
M a y -0 8

N o v -0 8
D e c -0 8
Ja n -0 9
F e b -0 7
M a r-0 7

S e p -0 7

F e b -0 8
M a r-0 8

S e p -0 8

F e b -0 9
O c t-0 7

O c t-0 8

It is worth noting the fact that, mineral oil sub-group alone manifested a
pronounced cyclical movement. It is in this context, the study took the time series
related to crude petroleum for a detailed study and analysis, to comprehend the
behaviour of various crude petroleum time series and to unearth what
determines the formation of crude petroleum prices and how it would impact the
economic well being.

7
Global Demand, Supply and Prices of Crude Petroleum

The appropriate indicator of Oil Prices

According to the International Energy Outlook, (Energy Information

Administration 2008, pp26) in every year since 2003, WTI (West Texas
Intermediate) is often considered as the indicator of world crude oil 2 prices as a
whole. But the Oil Market Report (International Energy Agency 2009, pp39)
points out that the unprecedented collapse in the WTI pricing structure over the
past six weeks, posited question marks regarding the relevance of WTI as a global
price benchmark.

Another view is that, the Brent crude produced in Northern Europe, which
is used as a benchmark for 60% of crude streams around the world, would better
serve as a measure of world crude prices (Wit and Smith 2008). At the very same
time, the OPEC basket average price cannot be sidelined altogether and is also an
important indicator of world oil prices, even though OPEC controls only around
35% of global oil supply. In this backdrop, Brent spot price and OPEC basket
average price are taken as indicators of price of crude oil at global level.

2
Crude oil: surface separating facilities. Depending upon the characteristics of the crude stream, it may
also include:
(1) Small amounts of hydrocarbons that exist in gaseous phase in natural underground reservoirs but are
liquid at atmospheric pressure after being recovered from oil well (casing-head) gas in lease separators and
are subsequently commingled with the crude stream without being separately measured. Lease condensate
recovered as a liquid from natural gas wells in lease or field separation facilities and later mixed into the
crude stream is also included;
(2) Small amounts of non-hydrocarbons produced with the oil, such as sulphur and various metals;
(3)Drip gases, and liquid hydrocarbons produced from tar sands, oil sands, gilsonite, and oil shale.
Liquids produced at natural gas processing plants are excluded. Crude oil is refined to produce a wide array
of petroleum products, including heating oils; gasoline, diesel and jet fuels; lubricants; asphalt; ethane,
propane, and butane; and many other products used for their energy or chemical content.

8
Demand, Supply and Prices of Crude Oil

The behaviour of the time series with respect to demand and supply of
crude oil is so patent that it treads through a plain terrain where there are no
noticeable humps or troughs. This behaviour needs to be discussed in
conjunction with the behaviour in crude oil prices that exhibits a cyclical
movement. The time series given below in the table and plotted in the figure are
quite instructive to ponder upon. The OPEC and Brent prices exhibit almost same
behaviour. Brent price is slightly above the OPEC price and is understandable
given its high quality compared to the low quality high sulphur rich OPEC oil.

9
 Table: 3 Demand, Supply and Prices of Crude Oil

World OPEC Non-OPEC OPEC Europe Brent

Year & World OPEC
Supply Supply m Supply Basket av. Spot Price
Month Demand 3 %
mb/day b/day mb/day price US $ /b FOB 4 US $ /b
Jan-05 83.60 28.80 54.80 84.80 33.96 40.24 44.51
Feb-05 84.30 29.00 55.30 84.80 34.20 41.68 45.48
Mar-05 84.20 29.10 55.10 84.80 34.32 49.07 53.10
Apr-05 84.50 29.40 55.10 82.60 35.59 49.63 51.88
May-05 84.60 29.30 55.30 82.60 35.47 46.96 48.65
Jun-05 84.60 29.30 55.30 82.60 35.47 52.04 54.35
Jul-05 84.70 29.32 55.38 83.20 35.24 53.13 57.52
Aug-05 84.90 29.70 55.20 83.20 35.70 57.82 63.98
Sep-05 83.80 29.80 54.00 83.20 35.82 57.88 62.91
Oct-05 84.40 29.60 54.80 84.20 35.15 54.63 58.54
Nov-05 85.00 29.60 55.40 84.20 35.15 51.29 55.24
Dec-05 85.00 29.30 55.70 84.20 34.80 52.65 56.86
Jan-06 84.60 29.20 55.40 85.60 34.11 58.29 62.99
Feb-06 84.60 29.60 55.00 85.60 34.58 56.62 60.21
Mar-06 84.50 29.70 54.80 85.60 34.70 57.86 62.06
Apr-06 85.10 30.00 55.10 83.60 35.89 64.44 70.26
May-06 85.00 29.80 55.20 83.60 35.65 65.11 69.78
Jun-06 85.20 29.80 55.40 83.60 35.65 64.60 68.56
Jul-06 85.50 29.80 55.70 84.60 35.22 68.89 73.67
Aug-06 85.80 30.00 55.80 84.60 35.46 68.81 73.23
Sep-06 85.40 29.80 55.60 84.60 35.22 59.34 61.96
Oct-06 85.30 29.40 55.90 85.70 34.31 54.97 57.81
Nov-06 85.40 28.90 56.50 85.70 33.72 55.42 58.76
Dec-06 85.40 28.80 56.60 85.70 33.61 57.95 62.47
Jan-07 85.50 30.20 55.30 86.20 35.03 50.73 53.68
Feb-07 85.50 30.20 55.30 86.20 35.03 54.45 57.56
Mar-07 85.30 30.10 55.20 86.20 34.92 58.47 62.05
Apr-07 85.50 30.30 55.20 85.10 35.61 63.39 67.49
May-07 84.90 30.10 54.80 85.10 35.37 64.36 67.21
Jun-07 84.30 30.17 54.13 85.10 35.45 66.77 71.05
Jul-07 85.30 30.50 54.80 85.70 35.59 71.75 76.93
Aug-07 84.60 30.40 54.20 85.70 35.47 68.71 70.76
Sep-07 85.10 30.70 54.40 85.70 35.82 74.18 77.17
Oct-07 86.50 31.20 55.30 87.20 35.78 79.36 82.34
Nov-07 86.50 31.10 55.40 87.20 35.67 88.99 92.41

3
Global demand for crude oil is quarterly averages given by Oil Market Report, International Energy
Agency, (various issues) for each calendar year.
4
Pertains to a transaction whereby the seller makes the product available within an agreed on period
at a given port at a given price; it is the responsibility of the buyer to arrange for the transportation and
insurance.

10
 World OPEC Non-OPEC OPEC Europe Brent
Year & World OPEC
Supply Supply m Supply Basket av. Spot Price
Month Demand 5 %
mb/day b/day mb/day price US $ /b FOB 6 US $ /b
Dec-07 87.00 32.00 55.00 87.20 36.70 87.19 90.93
Jan-08 87.20 32.00 55.20 86.80 36.87 88.50 92.18
Feb-08 87.50 32.10 55.40 86.80 36.98 90.64 94.99
Mar-08 87.30 32.10 55.20 86.80 36.98 99.03 103.64
Apr-08 86.80 31.90 54.90 85.70 37.22 105.16 109.07
May-08 86.60 32.30 54.30 85.70 37.69 119.39 122.80
Jun-08 86.50 32.40 54.10 85.70 37.81 128.33 132.32
Jul-08 87.80 32.80 55.00 85.20 38.50 131.22 132.72
Aug-08 86.80 32.50 54.30 85.20 38.15 112.41 113.24
Sep-08 85.60 32.30 53.30 85.20 37.91 96.85 97.23
Oct-08 86.90 32.10 54.80 85.00 37.76 69.16 71.58
Nov-08 86.50 31.30 55.20 85.00 36.82 49.76 52.45
Dec-08 86.20 30.90 55.30 85.00 36.35 38.60 39.95

Sources 7 :
1. Oil Market Report, International Energy Agency, (various issues) for
demand and supply figures.
2. Monthly Oil Market Reports, OPEC, (various issues) for OPEC Basket
average prices and supply.
3. "Energy Information Administration", Official Energy Statistics from
the US Government,
http://tonto.eia.doe.gov/dnav/pet/pet_pri_spt_s1_m.htm
for Europe Brent Spot Price FOB US $ /b

What is so palpable is the obvious disconnect between demand-supply

balance and the prices of crude oil which follows a cyclical path. This is the
conflicting movement, mentioned earlier, among the time series related to crude
oil in a phase of an economic cycle. The aggregate economy of the world as
whole is treading along a cyclical path and even the crude oil prices follow suit,

5
Global demand for crude oil is quarterly averages given by Oil Market Report, International Energy
Agency, (various issues) for each calendar year.
6
Pertains to a transaction whereby the seller makes the product available within an agreed on period
at a given port at a given price; it is the responsibility of the buyer to arrange for the transportation and
insurance.
7 For all the figures, the most latest reports are relied upon.

11
the demand and supply of oil refuses to follow and shows a conflicting behaviour.
Apart from that, throughout 2008, world demand is lower than the supply 8 , but
prices displayed a lucid cyclical path peaking at July 2008. What do they mean?

8 See Note: 2 (Global demand for crude oil is quarterly averages given by Oil Market Report,
International Energy Agency, (various issues) for each calendar year.)

12
 Figure: 2 World crude Oil Demand, Supply and Prices

World Crude Oil Supply World Crude Oil Demand OPEC Bechmark Price Brent Spot Price

140.00

120.00

100.00

80.00

60.00

40.00

20.00

0.00
Jul-05

Jul-06

Jul-07

Jul-08
Jan-05

May-05

Nov-05

Jan-06

May-06

Nov-06

Jan-07

May-07

Nov-07

Jan-08

May-08

Nov-08

Jan-09
Mar-05

Sep-05

Mar-06

Sep-06

Mar-07

Sep-07

Mar-08

Sep-08
13
 It only illuminates the stark yet familiar fact in a market economy that
prices often do not lay at the intersection point of actual supply and actual
demand but at the intersection point of perceived supply and perceived demand.
Wherefore, it becomes imperative to explore what influences the perceived
supply and perceived demand.

Crude Oil Prices and the Influence of ‘Fundamentals’

Often, when crude oil prices takes northward direction, it is often declared
from the roof-tops of market-friendly public offices, that this time, the price rise
is due to ‘fundamentals’ and there is no major speculative element beneath. The
main fundamentals that determine the oil prices are demand, supply and the
growth rate of the world economy. The first two are analysed and now the
importance of growth rate of the world economy in the price formation need to
studied. The table given below gives the relevant data.

Table: 5 Crude Oil Prices and Forecasted World Growth Rates

Growth rates forecasted for

Year & OPEC Basket av. Europe Brent Spot
the current year but revised in
Month price US $ /b Price FOB US $ /b
each current month
Jan-05 40.24 44.51 4.10
Feb-05 41.68 45.48 4.20
Mar-05 49.07 53.10 4.10
Apr-05 49.63 51.88 4.10
May-05 46.96 48.65 4.10
Jun-05 52.04 54.35 4.10
Jul-05 53.13 57.52 4.10
Aug-05 57.82 63.98 4.10
Sep-05 57.88 62.91 4.10
Oct-05 54.63 58.54 4.20
Nov-05 51.29 55.24 4.30
Dec-05 52.65 56.86 4.40
Jan-06 58.29 62.99 4.30
Feb-06 56.62 60.21 4.30
Mar-06 57.86 62.06 4.40
Apr-06 64.44 70.26 4.50

14
 Growth rates forecasted for
Year & OPEC Basket av. Europe Brent Spot
the current year but revised in
Month price US $ /b Price FOB US $ /b
each current month
May-06 65.11 69.78 4.70
Jun-06 64.60 68.56 4.70
Jul-06 68.89 73.67 4.70
Aug-06 68.81 73.23 4.80
Sep-06 59.34 61.96 5.00
Oct-06 54.97 57.81 5.00
Nov-06 55.42 58.76 5.10
Dec-06 57.95 62.47 5.10
Jan-07 50.73 53.68 4.50
Feb-07 54.45 57.56 4.60
Mar-07 58.47 62.05 4.60
Apr-07 63.39 67.49 4.70
May-07 64.36 67.21 4.80
Jun-07 66.77 71.05 4.90
Jul-07 71.75 76.93 5.00
Aug-07 68.71 70.76 5.00
Sep-07 74.18 77.17 5.00
Oct-07 79.36 82.34 5.10
Nov-07 88.99 92.41 5.20
Dec-07 87.19 90.93 5.20
Jan-08 88.50 92.18 4.70
Feb-08 90.64 94.99 4.60
Mar-08 99.03 103.64 4.60
Apr-08 105.16 109.07 3.90
May-08 119.39 122.80 3.90
Jun-08 128.33 132.32 3.90
Jul-08 131.22 132.72 4.00
Aug-08 112.41 113.24 3.90
Sep-08 96.85 97.23 3.90
Oct-08 69.16 71.58 3.80
Nov-08 49.76 52.45 3.70
Dec-08 38.60 39.95 3.60

Sources:
1. Monthly Oil Market Reports, OPEC, (various issues) for OPEC Basket
average prices and Global forecasted growth rates
2. "Energy Information Administration", Official Energy Statistics from the
US Government,
http://tonto.eia.doe.gov/dnav/pet/pet_pri_spt_s1_m.htm
for Europe Brent Spot Price FOB US $ /b

15
 3.25
5.25
7.25
9.25
11.25
13.25
Jan-05

Mar-05
Figure: 3

May-05

Jul-05

Sep-05

Nov-05

Jan-06
OPEC Price US$/0.1b

Mar-06

May-06

Jul-06

Sep-06

Nov-06

Jan-07

Mar-07

May-07
Brent Price US$/0.1b
Crude Oil Prices and Forecasted World Growth Rates

Jul-07

Sep-07

Nov-07

Jan-08

Mar-08

May-08

Jul-08
Ex. Growth Rate

Sep-08

Nov-08
16
 The forecasted growth rates for the world economy during April 2008 to
June 2008 virtually stagnated at 3.9%. But even during that period, the oil
prices 9 did not show any connection with the ‘fundamentals’ that should
determine the prices. Despite the stagnation in the forecasted growth rates for
the world economy, oil prices continued its climb which started from January
2007. The plotted series unambiguously manifest disconnect between
‘fundamentals’ and oil prices where the two series started to diverge as early as
December 2007 and the midriff widened till July 2008. Moreover, from
November 2007, the forecasted growth rates started to show what really lies
underneath and it became more pronounced from January 2008. By virtually
defying all these obvious indications or latent panic signals, oil prices skyrocketed
to stratosphere only to dovetail from August 2008. To sum up, the analysis shows
that global oil prices are not much influenced by ‘fundamentals’. It is to be
explored further to unearth the real factors that decisively influence the global
crude oil prices.

The Role of Futures Trading and the Elements of Speculation

Futures trading in crude oil are largely dominated by the New York
Mercantile Exchange (NYMEX) and Tokyo Commodity Exchange (TOCOM).
NYMEX 10 is more popular and deals with the high quality light sweet crude oil
with low sulphur content. NYMEX selected the landlocked city of Cushing,
Oklahoma in United States, as the physical delivery point for the futures
contracts because of its massive pipeline network and distribution infrastructure.

9 The oil prices are transformed to make it easy to present and visible in comparison with the
forecasted world growth rates. Normally crude oil prices are quoted for one barrel in US
dollars. For plotting the graph given above, these prices are transformed to represent price of
crude oil per 0.1 barrel (instead of one barrel) by dividing the per barrel price with 10.
10 At NYMEX, futures prices are quoted in dollars and cents per barrel and are traded in lot
sizes of 1000 barrels (42000 gallons). Contracts at NYMEX constitute the promise to buy or
sell crude oil in the city of Cushing, Oklahoma at a fixed price in a particular month in the
future.

17
Moreover, Oklahoma has close historical ties with the oil industry as it were
earlier an area of oil production. Later when oil supplies dried up there, NYMEX
identified it as an appropriate location point for the delivery of its futures with its
massive storage facilities of a staggering 45 million barrels of oil. The area’s
proximity to major oil producing and trading centres like Texas and the Gulf
Coast became the added attraction for its selection. Besides, it is sometimes
argued that NYMEX futures price is almost equal to the spot prices at Cushing,
Oklahoma. Anyway, all this gives—the NYMEX Cushing, Oklahoma crude oil
futures prices— a sort of universal acceptance for NYMEX futures.
The table given below shows the data of OPEC basket average and Brent
prices and the NYMEX futures prices.

18
Table:6 OPEC and Brent Prices and NYMEX Futures Prices

OPEC Basket Europe Brent Cushing, Oklahoma

Year &
average Price Spot Price Crude Oil Future
Month
(US $/b) FOB (US $/b) Contract 1 (US $/b)

Jan-05 40.24 44.51 46.85

Feb-05 41.68 45.48 48.05
Mar-05 49.07 53.10 54.63
Apr-05 49.63 51.88 53.22
May-05 46.96 48.65 49.87
Jun-05 52.04 54.35 56.42
Jul-05 53.13 57.52 59.03
Aug-05 57.82 63.98 64.99
Sep-05 57.88 62.91 65.55
Oct-05 54.63 58.54 62.27
Nov-05 51.29 55.24 58.34
Dec-05 52.65 56.86 59.45
Jan-06 58.29 62.99 65.54
Feb-06 56.62 60.21 61.93
Mar-06 57.86 62.06 62.97
Apr-06 64.44 70.26 70.16
May-06 65.11 69.78 70.96
Jun-06 64.60 68.56 70.97
Jul-06 68.89 73.67 74.46
Aug-06 68.81 73.23 73.08
Sep-06 59.34 61.96 63.9
Oct-06 54.97 57.81 59.14
Nov-06 55.42 58.76 59.4
Dec-06 57.95 62.47 62.09
Jan-07 50.73 53.68 54.35
Feb-07 54.45 57.56 59.39
Mar-07 58.47 62.05 60.74
Apr-07 63.39 67.49 64.04
May-07 64.36 67.21 63.53
Jun-07 66.77 71.05 67.53
Jul-07 71.75 76.93 74.15
Aug-07 68.71 70.76 72.36
Sep-07 74.18 77.17 79.63
Oct-07 79.36 82.34 85.66
Nov-07 88.99 92.41 94.63
Dec-07 87.19 90.93 91.74

19
 OPEC Basket Europe Brent Cushing, Oklahoma
Year &
average Price Spot Price Crude Oil Future
Month
(US $/b) FOB (US $/b) Contract 1 (US $/b)
Jan-08 88.50 92.18 92.93
Feb-08 90.64 94.99 95.35
Mar-08 99.03 103.64 105.42
Apr-08 105.16 109.07 112.46
May-08 119.39 122.80 125.46
Jun-08 128.33 132.32 134.02
Jul-08 131.22 132.72 133.48
Aug-08 112.41 113.24 116.69
Sep-08 96.85 97.23 103.76
Oct-08 69.16 71.58 76.72
Nov-08 49.76 52.45 57.44
Dec-08 38.60 39.95 42.04
Jan-09 41.52 43.44 41.92
Feb-09 43.32 39.26

Sources:
1. Monthly Oil Market Reports, OPEC, (various issues) for OPEC Basket
average prices and Global expected growth rates.
2. "Energy Information Administration", Official Energy Statistics from the
US Government,
http://tonto.eia.doe.gov/dnav/pet/pet_pri_spt_s1_m.htm
for Europe Brent Spot Price FOB US $ /b and
http://tonto.eia.doe.gov/dnav/pet/pet_pri_fut_s1_m.htm for NYMEX
futures prices.

The data sketches a close relation both in terms of behaviour and value
between all the three price series. The NYMEX futures price acts as the upper
bound for price movements. The only exception is for a small period from March
2007 to July 2007 where the Brent prices slightly overtook the NYMEX futures
prices because of temporary storage limitations faced at Cushing, Oklahoma. The
figure given below presents the simplified picture.

The figure delineates that in July 2008, the NYMEX futures prices took the
downward movement well before the OPEC and Brent series reached their

20
respective peaks. In July 2008, both the spot prices registered an upward
movement but the NYMEX futures price took a downward movement despite the
fact that the forecasted world growth rate for July 2008 is 4%, up from the June
rate of 3.9%. It is clear evidence that NYMEX futures know things better. But one
cannot take solace in the oft-repeated market slogan that market knows things
better and faster for this behaviour of NYMEX futures. We have seen the eye-
sight of market and its so-called efficiency during the era of sub-prime crisis. So it
is prudent to zero in the attention else where and obviously upon the speculative
forces so active in the futures markets.

The OPEC prices through out lie at the lower level and the Brent prices lie
just above it. Two interpretations are possible. First, NYMEX futures prices are
not much different from the Brent and OPEC spot prices. One implication is that
speculative elements in futures trading are not rouge. Second, NYMEX futures
prices acts as the benchmark for spot price fixation. Spot prices are always
looking upon the futures prices rather than the strength or weakness of
‘fundamentals’. Furthermore, it is already found that OPEC and Brent prices are
not at all influenced by demand, supply or forecasted growth rate of the world
economy. Hence, the close affinity of OPEC and Brent spot prices with NYMEX
futures prices only highlights the fact that these spot prices are gravitated by the
futures prices. As such, the implication is that speculative elements in futures
trading are exerting undue influence upon the spot crude oil prices.

The analysis so far accentuates that disconnect between demand-supply

balance and oil prices are so patent and suggesting. It is only in such a situation,
futures prices could exert influence upon spot prices of commodities, though
exceptions are possible. But they are exceptions only.

21
Figure:4 Relation between OPEC and Brent Prices and NYMEX Futures Prices
OPEC Price Brent Crude Oil Price Cushing, OK Futures Price

135.00

125.00

115.00

105.00

95.00

85.00

75.00

65.00

55.00

45.00

35.00
May-05

May-06

May-07

May-08
Mar-05

Nov-05

Mar-06

Nov-06

Mar-07

Nov-07

Mar-08

Nov-08
Jan-05

Jul-05

Sep-05

Jan-06

Jul-06

Sep-06

Jan-07

Jul-07

Sep-07

Jan-08

Jul-08

Sep-08

Jan-09
22
 Hence, the first interpretation is difficult to accept and the connection
between, both in behaviour and value, OPEC/Brent prices and futures prices
prompts to accept the second interpretation which punctuates the influence of
speculative elements in the futures trading of crude oil prices upon OPEC an
Brent prices.

However, the magnitude of influence of speculative trading in the futures

market upon world oil prices could be cemented only by considering and
analysing the net of long and short positions in the futures market along with
this.

Recapitulation

Prices of crude oil are a hot topic in the discussions of inflation in a

developing economy like ours. Market friendly public offices often try to mask the
real factors that influence the formation of prices of crude oil. Many a times, they
attempt to play down the reasons beneath the skyrocketing of oil prices by
suggesting that price rise is due to the influence of economic fundamentals like
soaring growth rate of the world economy, demand pressures, supply limitations
etc. They seldom mention about the role of speculative elements vigorously
engaging in the futures markets across the globe. In this backdrop, the study
attempted to dissect the reasons behind the cyclical movement of oil prices. It
found that there exist a glaring disconnect between demand-supply balance and
oil prices. Moreover, oil price movements often and crucially defy forecasts of
world growth rates and thereby strewn its own path led by factors better known
themselves. However, there is close connection between the NYMEX futures
prices of oil and the benchmark oil prices of Brent and OPEC oils, where in it
came to the inference that the OPEC and Brent spot prices are highly influenced
by the NYMEX futures prices. Last but not the least, the ‘oil price shock’ of 2008
is not a ‘supply shock’ as pointed out by the macroeconomic model of aggregate
demand and supply where ‘supply shocks’ are often referred as ‘price shocks’ and

23
hence needs to be understood as some thing under the guidance of the nether
side of market economy.

References

1. Bober, Stanley (1971): The Economics of Cycles and Growth, Wiley

Eastern Private Limited, First Wiley Eastern Reprint, New Delhi.

2. Energy Information Administration (2008): International Energy

Outlook, September, Washington DC

3. GOI (2009a): Index Numbers of Wholesale Prices in India—by Groups

and Sub-Groups (Monthly Averages), http://dbie.rbi.org.in/

4. GOI (2009b): ‘Inflation Rate, Wholesale Price Index and

Consumer Price Index’, Monthly Economic Scenario, February,
http://eaindustry.nic.in/mes/Crude_oil.pdf

5. International Energy Agency (various years): Oil Market Report, Paris,

France

6. Mankiw, N. Gregory (2002): Macro Economics, Fifth Edition, Worth

Publishers.

7. OPEC (various years): Monthly Oil Market Report, Vienna, Austria

8. Plosser, Charles L (1989): ‘Understanding Real Business Cycles’, The

Journal of Economic Perspectives, Vol. 3, No. 3, 51-78.

9. Wit, Joeri de and Smith, Aaron (2008): ‘What is the Price of Oil?’,
Agricultural and Resource Economics Update, Giannini Foundation of
Agricultural Economics, University of California, Vol. 11, No.5.

24