Throughout history, the availability of sources of energy and the means to produce, transport and harness it efficiently have been a necessary conditions for the growth of civilizations. Over the last century, fossil fuels have become the dominant source of energy globally, and companies have explored new sources and developed new technologies to access these reserves. But what is fuel without fuel consumers? Fossil fuels could have remained a topic confined to geologists' circles if it were not for the development and popularity of fossil fuel-based transportation machinery – such as cars, planes, and ships – has made these fuels essential to human life. It has been suggested that the usage of fossil fuels is an important factor behind the doubling of the world's population over the last century. Over the past few decades, the scarcity or abundance of these resources has been significantly influenced by the demand for these fuels, as consumers develop new uses for fuels, use fuels more efficiently, or substitute them with other energy sources.
This chapter emphasizes the strategic nature of energy commodities and introduces the energy markets by discussing the principal fuels transacted, the uses of these fuels, their origin, and how they are brought to market. Thereafter, the chapter examines the factors that influence fuel prices, including geopolitical risks and short-term supply/demand balances, as well as long-term fuel market considerations that contribute to the volatility of energy prices.
ENERGY AS A STRATEGIC RESOURCE
The importance of energy for present-day society cannot be understated. Energy is ubiquitous in the modern world, with every conceivable product and service utilizing energy for its production and delivery. Consequently, fluctuations in energy prices affect entities at all levels – from households and small businesses to large companies and governments – and the impact of price volatility is easily apparent. Rising energy prices impact a family's consumption basket, causing everything from transportation to groceries to become more expensive, thereby reducing their purchasing power. Higher fuel prices also mean that companies need to either absorb higher costs, raise output prices to maintain profitability, or otherwise manage the rise in costs. Finally, governments need to balance the subsidies given to energy consumers against deterioration in trade and budget metrics (e.g., fiscal and trade deficits) and potential social unrest. Even governments of energy-rich countries need to calibrate the amount of social support provided during periods of high energy prices in order to maintain a buffer for years when energy prices are low.
This increased awareness of the centrality of energy resources has been accompanied, over the last 30 years, by the development of sophisticated financial markets, the advent of the Internet, and electronic trading technologies allowing for more “democratic” access to commodities trading. Nowadays, investors, hedgers, and speculators are able to take control of thousands of oil barrels without leaving their chairs. Very often, the person trading these commodities has no personal experience with the physical commodity. Anyone can buy and sell commodities on trading platforms without even knowing the color of palladium, the location of gas pipelines, or the sea lanes used by very large crude carriers (VLCCs). Such abstraction from the details of the underlying physical commodity and its supply chain may be tolerable for some commodities, but is not advisable in the case of a “strategic” resource such as energy. The issue of security of production and supply is especially important for energy commodities, and this gives them a strategic dimension. Even experienced professionals like energy economists, who do a good job explaining energy prices in terms of supply and demand, can falter if they overlook the cost of securing supply and the security of trade routes.
To understand the importance of these details in the case of energy markets, let us use the analogy of a computer or a tablet. One can think of the commodities' physical platform as the hardware and the financial system as the software installed on it. The luxury of the touch screen and user-friendly graphic interfaces makes electronic technology easily accessible to everybody, to the point that one forgets about the existence of electronic circuits. It is perfectly understandable that more and more users find the workings of the hardware irrelevant, as long as they can use the apps. However if, hypothetically, the computer were to be used in conjunction with other devices to control the heartbeat or any other vital organ in the body, the concerned person would insist on learning about the safety mechanisms of the hardware, reading the manufacturer reviews, and even renegotiating his/her insurance scheme. Similarly, energy security cannot be discussed without a proper understanding of the commodities' physical platform. In a world where major energy chokepoints are prone to instability or turbulence, it is reasonable to assume that consuming nations must, directly or indirectly, bear the cost of securing energy supplies.
To further illustrate the strategic nature of energy, let us consider the case of China, which has become a major part of the energy equation, accounting for a significant fraction of oil demand growth. As a major oil consumer, China now commands the attention of market participants, who keep a close eye on the growth rate of the Chinese economy as any signs of a slowing of growth could send oil prices south. This simplistic analysis sometimes depicts China as mainly responsible for recent oil price volatility, either due to inappropriate monetary policy or industrial overcapacity, among other reasons. However, the situation looks quite different when viewed in the context of the petrodollar system.
Since the onset of the petrodollar system in the 1970s, most Asian oil-importing economies, including China, were obliged to export goods to the United States to lay their hands on the US dollars that were necessary to procure oil from Saudi Arabia and other Organization of Petroleum Exporting Countries (OPEC) members. China has been successful in leveraging its large workforce to build a significant manufacturing infrastructure capable of meeting (or exceeding) the US marke...
