Oil prices: The top 10 most important drivers

Demand

Economic growth has a strong impact on oil consumption. Increased demand for transportation (e.g. more car miles traveled), higher power generation and increased road building (uses bitumen, a derivative of oil) and other products such as plastic result in higher demand for crude oil. Expectations of stronger economic growth can result in higher oil prices as speculators anticipate higher demand for crude oil.

OPEC supply

Announcements by oil ministers from the most important oil producing countries within OPEC can also influence oil prices. Recognising that they can’t always adjust output rapidly in order to influence the price of oil, a strong statement of intent can often be enough to influence sentiment and result in higher prices during a period of seasonal weakness. Despite their influence OPEC have a poor record of sticking with their agreements. The conflict between members and non-OPEC producers means that there is an incentive for individual members to overproduce.

The degree of spare capacity, particularly from swing producer Saudi Arabia is a much watched indicator as to the degree to which the oil market can respond to unanticipated shocks. A smaller level of spare capacity is often a sign pointing towards higher oil prices.

Cartels can only influence the spot price and the shape of the forward curve however. Long dated prices (beyond two years to an extent, but certainly beyond five years) are generally out of the cartel’s control, as long as the cartel is not the marginal producer.

Non-OPEC supply

Non-OPEC members are not (typically) subject to any agreements on the amount of oil they produce. Oil companies produce the amount of oil they can do technically and economically at the price in the market for a given cost. Whether it be the rise of North Sea oil production or shale crude oil output in the US often non-OPEC oil producers can surprise on the upside, a perennial thorn in the side of OPEC.

Weather

If the weather is too windy (a hurricane, for example), then oil rigs and transport facilities operating in the US Gulf are likely to need to shut down or may even suffer damage. If there is a loss of oil production, this may lead to higher oil prices because the region’s refineries, which depend on the Gulf’s output, are forced to seek crude oil elsewhere. Meanwhile, very cold temperatures can mean that pipelines cannot be switched off – one of the reasons why it is difficult for Russia to support OPEC in cutting production during its winter.

Very warm and very cold temperatures, especially for prolonged periods, can dramatically increase the demand for crude and heating oil for cooling and heating, respectively, as opposed to the softening effect of more moderate temperatures. Saudi Arabia for example relies on oil to generate electricity. If the summer is particularly hot then more crude oil is used in power generation, resulting in less available to be exported.

US dollar

Like most internationally traded commodities oil is priced in US dollars. At its most basic a decrease in the value of the US dollar relative to a commodity buyer’s currency means that the purchaser will need to spend less of their own currency to buy a given amount of the commodity. As the commodity becomes less expensive demand for the commodity rises, resulting in an increase in the price and vice versa.

A weaker dollar can also act as a disincentive to producers to increase output. For example, a depreciation of the US dollar against the Russian ruble can reduce profit margins for oil companies in Russia. All of the oil producers revenues will be received in US dollars, which will now buy less rubles, but some proportion of the costs will be denominated in rubles and will remain constant (at least in the short term). Therefore, the prospect of a lower profit margin acts as an incentive to decrease the supply of oil.

The relationship between oil prices and the US dollar works both ways. For example, a decline in oil revenues from oil producing countries could result in them pulling money back that they have invested elsewhere in the world (the US, in particular) in order to help prop up their budgets. The repatriation of these so-called “Petrodollars” may then lead to a decline in the value of the US dollar.

War and conflict

A cursory look at a simple oil price chart dating back to the 1970s reveals a series of bumps. Each of these can be pinpointed to wars and conflicts, whether it was the Iranian revolution, the Iraqi invasion of Kuwait or the US-led invasion of Iraq in the second Gulf War. More recently, Arab Spring-related uprisings in Libya or Egypt have also affected the oil price.

The price chart for the first Gulf War is a good case study. The Iraqi invasion of Kuwait caused prices to spike higher, but then as soon as the US led ground invasion started oil prices fell back on speculation that the conflict would be brought to a swift conclusion and that the military would secure oil producing facilities.

Speculation

Oil and oil products tend to play a major role in commodity index funds that invest in a broad basket of commodities. Although the evidence is mixed some commentators have suggested that these funds have pushed oil prices higher than they would otherwise be.

Although the physical fundamentals of supply and demand prevail eventually, the physical market may not always be able to anchor futures prices for days, months or even years. It takes time for the market to divert and accumulate sufficient physical supplies from normal business channels to meet a rise in futures prices driven by speculative rather than fundamental factors.

Inventories

Stocks (otherwise known as inventories) act as form of buffer for both producers and consumers of a commodity. Typically, falling stock levels occur if demand increases faster than supply, resulting in a higher commodity price. Falling stock levels may, however, make a particular commodity market more vulnerable to an unanticipated disruption to supply or a sudden increase in demand.

Typically, there is an inverse correlation between stock levels and the price of oil. However, at different times in the market the fear among market participants may place a lower or higher premium on the overall level of crude stock levels. Other factors (listed in this article) may trump concerns over stock levels. In addition, although relatively robust data exists in the US and many other OECD countries, other parts of the world are much more opaque.

Strategic Petroleum Reserves

One of the most well known strategic reserves is the US’ Strategic Petroleum Reserve (SPR), the largest emergency supply in the world with the capacity to hold up to 727 million barrels of oil. Most recently, it was used to offset disruptions to oil supply in the US Gulf following Hurricane Katrina in 2005 and following the political upheaval and loss of oil production in Libya in 2011. Just the threat of a release from the SPR has often been enough to temper an increase in the oil price, particularly when there has not been any actual cut to output.

More recently, other countries such as China have sought to establish their own SPR’s, often entering the market when oil prices are relatively low to build up their reserves.

Unplanned outages

Unplanned outages can result in higher prices. Possible reasons include the weather, maintenance, war or civil unrest etc. For example Nigerian crude output has been frequently disrupted due to armed gangs that blow up pipelines.

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Peter Sainsbury

Materials Risk provides commodity market insights across your supply chain by highlighting emerging risks and opportunities and providing advice on commodity buying and managing risk. All views expressed on this website are those of Materials Risk only. See our About page and terms and conditions for more details. Materials Risk was founded by Peter Sainsbury who you can follow on Google+ and Quora