Crude oil is the world’s most traded commodity and as time progresses, it seems like its role in the global economy intensifies even more. Starting in 1901, the ear of modern oil production started as it quickly replaced coal as the world’s primary source of fuel. Today in Suzzanne Uhland’s blog, we want to take a look at what is it that regulate the prices of oil and why they fluctuate the way they do.
Since oil is such a precious commodity and its acquisition is so crucial that it can affect global economies in major ways, there are two main factors that primary impact the price of oil: the supply and demand, and market sentiment.
The concept of supply and demand is not new by any means, but it pretty much means that as the demand increases and the supply decreases, the price of oil will go up and vice versa. This has a lot to do with what we call peak oil and it is something we have mentioned in a previous article. Inevitably, when peak oil is reached, prices will rise dramatically as supply will decrease and demand will increase noticeably. Those surges in prices will affect everything else in the market because energy costs will increase and so will transportation expenses.
Market sentiment refers to the overall attitude of investors towards a particular market, in this case, that market is oil as a commodity. Commodity traders bid on oil future contracts in order to sell or buy oil in the future at an agreed-upon price. These future traders are known as either hedgers or speculators. Hedgers normally represent companies that use oil as a resource for their business, like airlines, transportation, and energy companies. What these companies want to do is to secure the resource for their daily operations, so they buy the oil for future delivery and that way they can plan financially, and reduce the risk of the investment for their corporations. Speculators on the other hand, simply try to guess in which direction the price of oil will head next and make high-risks investment with the purpose of making a profit from the changes in the market.
The Organization of the Petroleum Exporting Countries or OPEC is another key player on the fluctuation of oil prices. OPEC’s purpose is to coordinate and unify policies amongst the main countries producing oil and therefore secure fair prices for petroleum producers.
While this is supposed to be true in theory, it doesn’t always happen that way as we have seen during times of political unrest that have lead to embargos and thus the increase of prices.
If OPEC declares a production cut, then the supply of oil decreases and then the prices increase. The same can happen the other way around, if there is a raise in the production ceiling, then more barrels are exported and this increase in supply pushes prices down.
When prices are too high, it becomes profitable to look at more expensive ways of producing crude oil like it is the case of U.S. shale oil. While fracking is a controversial topic, it has been used as an alternative way to push back upon the pressure created by OPEC quotas.
Another alternative that allows counteracting freezes in production or a lower supply of crude oil is the authorization to access strategic oil reserves. When oil prices got too high in the 70’s because of the embargo, the United States created this strategy in order to release reserved oil into the market and those compensate for the increase in demand that comes as a consequence of the freeze.
The possibility of a crisis in nations that produce oil are a cause of concern to traders who believe that supply may become limited, and it usually ends up becoming another factor that affects the price of oil in the market. This was evident during the Arab Spring in 2011, when oil prices went over $100 a barrel and stayed there for several months, impacting global prices.
Something else that majorly affects the prices of oil is global economic growth. As economies growth and countries become more prosperous, they begin to use more energy and create an increase in demand for crude oil. China, for example, has been a key player on this factor for the last few years. As other economies are no longer on top and China has taken their place their place as the world’s number one crude importer, analysts have forecasted a growth in demand that will make prices fluctuate in the near future.
The automotive industry is a place where many look today with the expectation of a great impact on oil prices. As technology advances, automakers and trying to find ways to move away from internal combustion engines and looking for new alternatives. The transportation industry accounts for two-thirds of crude oil demand, so whatever happens, it could have major consequences.
* Featured Image courtesy of Geof Wilson at Flickr.com