Encyclopedia of Quantitative Finance, IV Volume Set

Occupation Time Derivatives see Corridor Options

Oil Market

The development of the internal combustion engine one century ago was the principal cause of the development of the oil market. In the 1950s, oil became more important than coal. Since then its importance has kept increasing, though it has been recently largely displaced by natural gas for heating and electricity generation. The rapid economic growth of China and of India has increased the world demand for oil. Currently, demand exceeds 90 billion barrels a day, stretching the global production capacity.

Bringing new oil fields to production requires typically several years and very large investments. The economic hurdles are compounded by environmental worries and by the unstable market structure of oil. Market instability is due to the low short-term elasticity of oil consumption to price changes. The large price fluctuations implied by the low elasticity of oil prices being related to trends in world economy carry a substantial risk premium that increases the cost of capital for oil projects. Over longer time periods, high prices discourage demand and increase production. Lower prices have the opposite effects. This leads to substantial mean reversion in oil prices over longer intervals. Over the long run, real oil prices have been mostly declining in real terms, with the exception of 1973–1981 and the current uptrend ...