What affects oil prices?

Oil is a highly sought-after commodity. It is one of the most valuable resources as much of the world’s industry is reliant on oil. However, it is also one of the most volatile commodities as it is very susceptible to geopolitical events.

Pair this with the fact that many of the world’s largest reserves are found in unstable regions of the world, chiefly the Middle East, Africa and parts of South America, and it becomes evident why the price of oil is in a constant state of flux.

The key to understanding oil’s price is the relationship between supply and demand. Prices will rise in line with demand (assuming supply remains static) and fall as supply rises (assuming demand is static). With that in mind, let’s take a look at the key drivers of supply and demand.

Supply factors that affect oil prices

OPEC

OPEC, the Organisation of Petroleum Exporting Countries, is a cartel made up of 14 countries who export petroleum. Cartel in this instance means that the countries within OPEC have come together to regulate the price of oil by controlling supply.

OPEC have done this because although oil is a finite resource, many countries have access to their own oil fields and means of production. As such, OPEC was formed to protect against a race to the bottom in terms of prices, which would have resulted in rapid depletion of these countries’ reserves. Therefore, OPEC was formed to regulate oil production via quotas, which ensures members get a good price for their oil even if this means producing less in the short term. In 2018, OPEC countries agreed to limit production to around 39 million barrels of crude oil per day, more than a third of global daily crude oil production.

OPEC used to hold considerable influence over the price and supply of oil. This was evidenced in 1973, when the so-called ‘oil crisis’ saw global crude oil prices nearly quadruple as OPEC restricted supply to a number of countries. More recently, however, OPEC has warned that the oil market could be heading towards a surplus as a result of the expansion of the American fracking industry. This expansion has led to OPEC's influence declining in the last decade or so.

Russia currently works with OPEC as a non-member. It has agreed to limit production several times in recent years, most recently by around 228,000 barrels per day in December 2018.

Non-OPEC oil producing countries

Outside of OPEC, the world’s biggest oil producing countries are the USA, Canada and China. In terms of single oil producing countries, the USA is the world’s leader with 13 million barrels a day being produced in 2017.

There is also the OECD, the Organisation for Economic Cooperation and Development, whose members produce around 24 million barrels per day. As a whole, non-OPEC nations produce somewhere in the region of 53 million barrels of crude oil a day.

Source: BP, 2017

Exogenous shocks

Events that economics cannot explain or control, such as natural disasters, war and geopolitical instability can all impact the price of oil. For example, when Hurricane Katrina hit the east coast of America in 2005, it damaged vital oil supply lines, causing an oil crisis in America. As a result, between 29 August and 5 September 2005, prices for fuel rose more than half a dollar in some parts of the country.

This was then exacerbated by a media frenzy in which it was said that supply of fuel would soon run out, which led to queues of people forming at petrol stations to fill up their tanks. The shortages were so severe that President George W. Bush released 30 million gallons of fuel from the American strategic reserves in an attempt to prevent fuel prices escalating further.

Source: US Energy Information Administration, 2005

Demand factors that affect oil prices

Global economic performance

The main drivers of the demand market for oil are the USA, Europe and China. Combined, these three consume around 45 million barrels of crude oil per day. The strength of their economies – and global economic performance – can therefore affect the price of oil significantly.

The 2008 financial crash, for instance, brought about a slowdown in industry which in turn lowered the need for oil. Without a similar drop in oil supply, the price of Brent Crude declined by over $100 in a five-month period.

Source: BP, 2017

However, when industry recovers which it often does, the price of oil will start to recover. For instance, oil prices were back to over $100 per barrel three years after the 2008 crash. From there, oil prices remained above $85 until August 2014. Currently, the world consumes around 98 million barrels of crude oil per day. There is speculation over whether the demand for oil will remain this high in the coming years, due in part, to the development of renewable sources of energy.

Alternative energy sources

An increased awareness of the benefits of renewable energy sources such as solar and wind could see a decline in the world’s reliance on oil. Electric cars are also responsible, as are pledges by various governments to ban the production of new petrol and diesel cars in the years ahead.

This could see oil prices fall as supply may remain high. However, in the event of dwindling demand, it is also likely that OPEC and other oil-producing parts of the world will reduce their supply to keep prices at a profitable level.

Source: Statista, 2016

The EU has set itself a target of having renewable energy sources make up 20% of energy consumption on the continent by 2020, and countries such as Denmark are aiming to be completely free of fossil fuels by 2050.

Traders who deal in the oil market should keep an eye on the development and increasing popularity of alternative energy sources to ensure that they are placing trades in line with industry trends.

Strength of the US dollar

Following the Bretton Woods conference in 1944, the US dollar was pegged to the price of gold and every other currency was pegged to the dollar. As a result, the dollar became the world’s reserve currency, and oil was bought and sold in US dollars. Even though the US scrapped the gold standard in 1971, oil is still exchanged in US dollars.

This means that the value of the dollar has a major impact on the price of oil. If the dollar becomes stronger, for instance, the price of oil will tend to drop – at least nominally – assuming that all other factors remain constant.

Conversely, if the dollar is weak then prices of crude oil will tend to rise.

Market speculation

Oil prices are set on the futures markets, which means that market speculation about future events could impact oil’s price. For example, if China chose to build more nuclear power plants, demand for oil could drop substantially.

An increase in global fracking, on the other hand, could see oil supplies rise further and increased speculation in the oil market. However, with various world governments including France, Germany and Ireland having banned fracking, the expansion and development of the fracking industry as another source of oil is uncertain.

How to trade oil

Knowing how to trade oil requires a trader to monitor all of the listed factors. So, if you are interested in speculating on its price, you should pay attention to factors including OPEC meetings and news surrounding possible slumps in global oil supply, such as any legislation which could impact the fracking industry or enhance the renewable energy sector.

Remember, oil is arguably one of the most volatile markets in the world. Its price is tied heavily to politics and the decisions made by world leaders and governments, and this is especially true at the moment with the future of the industry being so uncertain.