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.

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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.

Previous episodes

Silver prices: The top 10 most important drivers

Natural gas prices: The top 10 most important drivers

Copper prices: The top 10 most important drivers

Livestock prices: The top 10 most important drivers

Sugar prices: The top 10 most important drivers

Gold prices: The top 10 most important drivers

Buy the book Commodities: 50 Things You Really Need To Know from Amazon (US and UK), iBooks, Barnes and Noble, Google and Kobo.If you like the book please leave a review on Amazon. Reviews really do make a difference. Thanks.

Most read articles of 2016: What a year

Over the course of 2016 one of the main areas of focus for commodity markets has been geopolitical risk, and so it has been reflected in the most popular posts of the year on Materials Risk with concerns over the US election and the EU referendum in the UK the top of investors concerns.

Despite the interest in how politics affects markets one of the main takeaways from the year has to be how it is important to focus on how the ‘narrative’ changes once an election outcome is known – gold and other precious metals have been the primary casualty since the middle of 2016 as despite investor fears materialising the price of gold as gone in the opposite direction to which ‘pundits’ have forecasted.

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The other posts that have gained lots of interest have been on the perils and challenges in forecasting commodity prices and the things that investors need to watch out for so that they are not sayed by the ‘pundits’ that present a one-sided view of the world. 2017 will mark the release of my second book that looks on this  topic (check out more on the first here).

Interest in what factors affect various commodity markets is also reflected in the most popular posts with interest the series of posts on ‘The top 10 most important drivers’ featuring highly during the year. This is an issue that we will be focusing on more of during 2017 both in articles and perhaps using a different medium (watch this space).

If you would like to make a suggestion for what this site could cover in 2017 you can use the orange feedback box on the right side of this page. That only leaves me to say Happy New Year and hopefully see you in 2017.

1) What does a Trump Presidency mean for commodities?

2) Silver prices: The top 10 most important drivers

3) Wheat prices: The top 10 most important drivers

4) What does Brexit mean for commodity markets?

5) Cotton prices: The top 10 most important drivers

6) Crude returns: How low oil prices have broken the relationship to food prices

7) Gold prices: The top 10 most important drivers

8) Oil price scenarios ahead of Doha meeting

9) Low and behold: Oil price forecasts for 2016 including one for $5 per barrel

10) History suggests that soybean price rally is not built on stable foundations

Buy the book Commodities: 50 Things You Really Need To Know from Amazon (US and UK), iBooks, Barnes and Noble, Google and Kobo.If you like the book please leave a review on Amazon. Reviews really do make a difference. Thanks.

Materials Risk Christmas Quiz

Listed below are 7 questions to test your knowledge on commodities over the Christmas break. No particular reason why there are 7 questions, that was just about all I could think up. No prizes either unfortunately. Anyway, Merry Christmas.

Question 1: What is the main goods export of Christmas Island?

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a) Phosphate
b) Iron Ore
c) Passion Fruit
d) Cranberries

Question 2: Lapland (the northenmost part of Finland, where Father Christmas lives with his elves) has no fossil fuels. How much oil and oil products (in thousand barrels) did Finland import per day in 2011?

a) 343
b) 267
c) 427
d) 526

Question 3: How much has the cost of Christmas pudding ingredients (in the UK) changed by over the past twelve months?

a) +32%
b) +21%
c) +7%
d) unchanged

Question 4: Assuming you have a ceiling tall enough to fit one, how long does it take to a Norman Spruce tree to grow from a seedling to 5m?

a) 10 years
b) 13 years
c) 15 years
d) 20 years

Question 5: What is the northernmost OPEC country?

a) Algeria
b) Iran
c) Venezuela
d) Nigeria

Question 6: Assuming a fuel efficiency of 5 miles per gallon and jet fuel costs $1.50 per gallon how much does it cost Father Christmas to deliver all the presents on Christmas Eve?

a) $68m
b) Nothing of course, its all magic
c) It depends
d) $51m

Question 7: Assuming the gold jug thing and the tray in the celebrated depiction of the delivery of the three gifts by 16thcentury Greek artist El Greco weighs 3kg, how much would the gold be worth today?

2016-12-22_0553

a) $109 thousand
b) $75 thousand
c) $210 thousand
d) $385 thousand

View the answers

Buy the book Commodities: 50 Things You Really Need To Know from Amazon (US and UK), iBooks, Barnes and Noble, Google and Kobo.If you like the book please leave a review on Amazon. Reviews really do make a difference. Thanks.