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Debt and Derivatives Usage to Blame for Oil Price Collapse

© Flickr / Steven StraitonOffshore oil rig, North Sea
Offshore oil rig, North Sea - Sputnik International
An analysis published by the Bank for International Settlements pinpoints a substantial increase in debt and the use of financial derivatives in the energy sector as having been significant factors in bringing about the recent fall in oil prices.

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The Bank for International Settlements [BIS] has issued an analysis of this year's collapse in oil prices, remarking that instead of being driven by changes in supply or demand like the declines of 1996 and 2008, the sharp fall in oil prices is more likely due to the increase in debt and use of hedging instruments in the sector to reduce risk.

"Changes in production and consumption seem to fall short of a fully satisfactory explanation for the abrupt collapse in oil prices," said the BIS in its findings. The Swiss-based BIS, founded in 1930, was the world's first international financial organization to specialize in providing advisory services to central banks and international organizations on monetary and financial stability.

"Rather, the steepness of the price decline and very large day-to-day price changes are reminiscent of a financial asset. As with other financial assets, movements in the price of oil are driven by changes in expectations about future market conditions. In this respect, the recent OPEC decision not to cut production has been key to the fall in the oil price", the BIS report continued.

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According to the figures published by the BIS, energy firms have issued increasing numbers of debt securities, rising from $200 billion worth in 2002, to over $800 billion this year, rising far faster than the general market and abetted by the readiness of investors to lend against oil reserves and revenues.

Consequently, a fall in the oil price is exacerbated by the necessity on the part of producers to continue high levels of production in order to maintain cash flow and service their debt, while the possibility of selling futures is a way for producers to hedge their exposure to volatile revenues. BIS also points to the rising role of intermediaries such as swap dealers when addressing the availability of liquidity for oil producers, and the influence of such investors' cyclical behavior.

Oil instrument broker PVM  told the Financial Times on Saturday that the daily futures volume in oil has risen from 3.4 times global demand in 2005 to its current level of more than 20 times the  global demand for oil.

Until last year's collapse, the price of oil had kept to a relatively stable level of around $100 per barrel since 2010. However, recent volatility has seen a drop of around 50 percent in its price since June, when Brent crude was selling for as much as $110 a barrel. In January the price dipped as low as $44 per barrel. According to data from Marketwatch, Brent crude is currently selling at $59.09 per barrel, following a volatile rebound at the beginning of this month which saw its price increase by 20 percent in just four days.

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