One of the world’s primary energy resources, crude oil has always been in high demand and traded in large volumes. This commodity can be refined into various other products, such as petrochemicals, lubricants, gasoline and wax, making it very sought after. The oil markets are highly liquid, translating into tighter spreads and clear chart patterns for traders.
However, oil prices
are very sensitive to geo-political events. Along with that, the major oil reserves are located in politically unstable regions of the world, such as the Middle East and South America. This is why prices tend to be in a constant state of flux. In order to determine the factors that impacts oil prices, one has to understand the relationship between its supply and demand. A rise in demand will lead to an increase in price, provided that the supply remains constant, and vice versa.
Supply Side of Oil Prices
The Organisation of Petroleum Exporting Countries (OPEC)
, an alliance of 15 countries involved in the production and export of oil, contributes about 40% of the global oil supply. The organisation actively controls oil production in the member countries, by setting production targets. OPEC’s oil exports constitute 60% of the total petroleum traded in the international markets. This huge market share makes OPEC an important factor in oil prices. Historically, crude oil prices have risen whenever the OPEC countries have reduced production. In particular, actions by Saudi Arabia, OPEC’s largest oil producing country, can impact oil prices.
OPEC member countries’ production capacities and the extent to which they utilise it, is said to be an indicator of the tightness of the global oil markets. Also important is the projected future supply and demand. OPEC meetings, held in Vienna a few times a year, are where member countries decide on their production quotas. These meetings coincide with huge volatility in oil prices.
In the December 2018 meeting, OPEC decided to curb production by 1.2 million barrels per day in 2019. Keeping an eye on how these cuts are brought into effect is a key aspect in assessing the supply side of oil.
Outside of OPEC, some of the biggest oil producing regions are North America, China, North Sea and regions of the former Soviet Union. These countries, including USA, Canada, China and the UK, make their oil production decisions independently. Oil production in the OPEC countries are carried out mostly by national oil companies, whereas the main players in non-OPEC production are international and investor-owned oil companies.
These countries are price takers, which mean that they react to changes in market prices, rather than controlling production to influence it. Low levels of production in these countries put pressure on the OPEC countries, which can then lead to increasing prices. Increase in supply from non-OPEC countries keeps prices low. Advancements in production technologies in these countries could bring down the high cost of offshore drilling, putting downward pressure on prices.
Demand Side of Oil Prices
Demand from OECD Countries
The Organisation of Economic Cooperation and Development (OECD) comprises of the USA, large parts of the EU, including the UK, and several other advanced nations. By 2010, these countries were consuming 53% of the world’s crude oil supply. The economic structure of each country has an effect on industrialisation and the resulting oil demand.
Developed nations tend to have higher per capita vehicle ownership. Policies that deal with transportation of citizens and goods have an effect on demand for oil for fuel. Demand from highly industrialised nations, like the USA, has an effect on oil prices, the estimates of which are provided by the Energy Information Agency (EIA).
There are fewer subsidies on end-user oil prices in these countries, so market prices are quickly reflected in the price consumers pay.
Demand from non-OECD Countries
Oil consumption in some developing nations has risen over the past few years. Between 2000 and 2010, this consumption grew more than 40% in countries like China, India and Saudi Arabia. Expected levels of economic growth tend to have a significant influence in oil demand.
Oil remains an important source of power generation, as well as of fuel for commercial and individual transportation. Manufacturing activities need oil too. In recent years, China has managed to become the second largest oil consumer in the world. Energy policies also have an effect on the relationship between economic activity and oil prices. An improved economic outlook raises expectations of tightening oil markets in the future, and, as a result, higher oil prices.
Effect of Major Geo-Political Events
Apart from economic activities, other events like wars, natural disasters and political crises impact oil prices. For example, when Hurricane Katrina hit the US coast in 2005, it damaged important supply lines.
In the aftermath of the US-China trade war, manufacturing activities in both nations have been negatively impacted. GDP growth expectations have been lowered for 2019 and 2020, which can impact oil prices. After all, the US and China are the two largest oil consumers in the world.
Sanctions on Iran and decisions regarding renewal of waivers
by the US will have a major impact on oil prices in 2019. Also to be considered is the reluctance of Russia to form any long-term alliance with Saudi Arabia, saying that it is content with lower oil prices.
Speculation in the Futures Markets
The oil futures market plays a major role in price discovery, and therefore has a major impact on oil prices. Participants in this market include large corporations, like airline companies, which mostly want to hedge their risks with exposure to changing prices of oil and petroleum-based fuel products.
Other players include banks, hedge funds, money managers and commodity traders, who are actively involved in the energy derivatives markets to capture profits from price fluctuations. Individual traders mostly want to diversify their portfolios and hedge inflation risks.
The Commitment of Traders Report, released by the Commodity Futures Trading Commission, a weekly report of oil trading activities on various exchanges, is something traders can keep their eye on.
These and many other factors, like stock performances and performance of the US Dollar, show correlations with oil prices. Exchange rates and other economic factors affect oil production and demand, possibly affecting price correlations.