What determines oil prices?
Despite efforts to decrease its use and find other green energy sources, oil still plays a significant role in the world’s economy. In those early days, oil drilling was considered a nuisance because the intended treasures were usually water or salt. It was not until 1847 that the Absheron Peninsula, Azerbaijan, saw the first commercial oil well. 1 In 1859, the U.S. Petroleum industry was created with the intentional drilling near Titusville in Pennsylvania. The United States started drilling in the 1800s. However, they were only drilling for brine, and any oil discovery was accidental.
Although kerosene was the primary oil demand, in the beginning, the first commercial well capable mass production was not drilled until 1901 at the Spindletop site in southeastern Texas. 4 This site, known as Spindletop in southeastern Texas, produced more than 100,000 barrels per day.
Oil’s use in fuels is still the main factor that makes it a highly-demand commodity across the globe. But how do prices get determined?
- As with most commodities, oil’s fundamental driver is supply and demand.
- The oil markets are made up of both speculators who bet on price movements and hedgers who limit risk in the production and consumption of oil.
- The cartel of oil-producing countries called OPEC helps control the supply of oil.
- Everything from gasoline for cars and air travel to electric generation drives oil demand.
What drives oil prices?
The Factors That Determine Oil Prices
Oil’s status as a highly-demand commodity worldwide means that major price fluctuations can have significant economic consequences. Two main factors that affect the oil price are:
- Supply, Demand
- Market sentiment
It is easy to understand the concept of demand and supply. The price should rise with more demand (or less supply). The price should decrease if demand is lower or supply increases. It sounds simple.
Not quite. It’s not. The seller and buyer must honour their respective parts of the futures contract by the deadline.
Oil prices plummeted in the wake of the global economic slowdown. Despite the economic slowdown, oil prices plummeted in spring 2020.
These are the two types of futures traders.
A hedger is an airline that buys oil futures to protect against rising prices. A speculator speculates on the price direction but has no intention to buy the product.
The sentiment is another key factor that determines oil prices. The sentiment is another key factor in determining oil prices. Simply believing that oil demand will rise dramatically in the future could lead to a dramatic increase in current oil prices as hedgers and speculators alike buy oil futures contracts. The opposite can also be true. However, the opposite can also be true.
The Economics of Oil Prices Doesn’t Add up.
The basic supply and demand theory says that the more products are produced, the less they should be sold, all things being equal. It’s a symbiotic relationship. It can produce more goods if it becomes more economically efficient or less economically efficient. A good stimulation technique could be invented that would double the output of an oilfield for a minimal incremental price. Demand will remain static, and prices will fall.
There have been times when the supply has increased. There have been periods when supply has increased.
This is where theory meets practice. Although production was high, distribution and refinement could not keep up. The United States has averaged one refinery per ten years (construction has slowed down to a trickle ever since the 1970s). It’s a net gain: The United States has 2 fewer refineries now than in 2009,10,11 But, they still have 135 refineries.
The Commodity Price Cycle and Oil Prices
Historical perspective also suggests a possible 29-year cycle (plus or minus 1 or 2 years) that regulates the general behaviour and prices of commodities. Major peaks in the commodities index occurred in 1980, 1958, and 1920. This is since the rise of oil as a highly-demand commodity in the early 1900s. The commodities index reached its peak in 1980 and 1920. Note: There was no peak in oil in 1958. It had been moving in a sideways direction from 1948 and continued doing so until 1968. It’s important to remember that cycles are not rules but guidelines.
Oil prices are affected by market forces.
Although the charter of OPEC doesn’t specifically state it, OPEC was established in 1960 to fix oil and gas prices. OPEC can limit production and make profits at a higher rate than if each member country had sold their oil on the global market at the current rate. This sound strategy was followed by OPEC throughout the 1970s and most of the 1980s.
P. J. O’Rourke said that “certain people enter cartels out of greed. Then, out of greed, they attempt to get out of cartels.” According to the U.S. Energy Information Administration (USEIA), OPEC member nations often sell more oil than they have quotas. This makes it difficult for them to achieve their mission to “ensure the stability of oil markets to ensure an efficient, economical and regular supply to consumers.” Although the consortium has pledged to keep oil prices above $100 per barrel in the future, in mid-2014, it refused to reduce oil production from a peak at above $100 per barrel to below $50 per barrel.
The bottom line
Unlike most other products, Oil prices are not determined solely by market sentiment towards the product. Instead, price determination is influenced by supply, demand and sentiment towards oil futures contracts. Speculators heavily trade these contracts. The commodities market could also be affected by cyclical trends. It doesn’t matter how oil is priced, but it does depend on how much oil is used in fuels and the many consumer products. This suggests that oil will be in high demand in the future.