What Affects Oil Prices? Three Critical Factors
The Behind-the-Scenes Role of Commodities Traders
Traders base their bids on their perceptions of supply and demand. Other entities can affect the traders' bidding decisions through their actions. These influencers include the U.S. government and the Organization of Petroleum Exporting Countries.
Oil futures contracts are agreements to buy or sell oil at a specific date in the future for an agreed-upon price.
Oil futures contracts are executed on the floor of a commodity exchange. U.S. commodities have been traded for more than 100 years. The traders are registered with the Commodities Futures Trading Commission. The CFTC has regulated them since the 1920s.
Commodities traders fall into two categories. Most are representatives of companies who actually use oil. They buy oil for delivery at a future date at the fixed price. That way, they know the price of the oil, can plan for it financially, and so reduce or hedge the risk to their corporations.
Traders in the second category are speculators. Their only motive is to make money from changes in the price of oil.
- Traders control oil prices through bids on futures contracts.
- Bids are based on current and future global supply and demand.
- Man-made and natural crises make huge impacts on oil prices.
Three Factors Traders Use To Determine Oil Prices
There are three main factors that commodities traders look at when developing the bids that create oil prices. They are current supply, future supply, and demand.
Current supply is the total world output of oil. OPEC supplies of 60% of the world's oil exports. The United States has cut into its market by extracting shale oil. Between January 2011 and December 2014, U.S. shale oil production quintupled from 1 million to 4.9 million barrels per day. That created an oil glut. By February 2016, traders had sent the price of imported oil down to $29 per barrel.
As of March 2020, there is a glut of oil. U.S. shale production reached a peak of 8.2 million barrels per day in November 2019. In December, China announced the first case of coronavirus. In January 2020, governments began closing businesses to stem the pandemic. By April, 40% of the world's population had been told to stay at home.
Instead of cutting supply, OPEC and Russia increased production to maintain market share. As storage facilities filled, prices plummeted into negative territory. No one wanted delivery of oil since there was hardly any place to store it.
Access to future supply depends on oil reserves. It includes what's available in U.S. refineries as well as in the Strategic Petroleum Reserves. These reserves can be accessed very easily to increase oil supply if prices get too high. Saudi Arabia can also tap into its large reserve capacity.
Traders look at world oil demand, particularly from the United States and China. U.S. estimates are provided monthly by the Energy Information Agency. Demand rises during the summer vacation driving season. To predict demand, forecasts for travel from AAA are used to determine potential gasoline use. During the winter, weather forecasts are used to determine potential home heating oil use.
The oil price forecast has shown such volatility in prices because of the changes in oil supply, dollar value, OPEC’s actions, and global demand.
Effect of Disasters on Oil Prices
Natural and man-made disasters can impact oil prices if they are dramatic enough.
COVID-19 Coronavirus Pandemic
In January 2020, many governments began restricting travel and closing businesses to stem the coronavirus pandemic. Demand for oil began falling. In the first quarter of 2020, oil consumption averaged 94.4 million barrels per day, down 5.6 million b/d from the prior year.
A drop in demand was worsened by a supply glut. On March 6, Russia announced it would increase production in April. To maintain market share, OPEC announced it would also increase production.
As storage facilities filled, prices plummeted into negative territory. Traders were willing to pay someone else to take delivery of the oil since there was hardly any place to store it. On April 12, 2020, OPEC and Russia agreed to lower output to support prices. But it wasn't enough to convince traders that supply wouldn't outpace demand. As of April 20, 2020, the prices for a barrel of oil had fallen to -$36.98.
Hurricane Katrina was a Category 5 hurricane that hit Louisiana on August 29, 2005. Between Aug. 29 and Sept. 5, the U.S. average price for regular gasoline rose 46 cents to $3.07 per gallon. It was the largest weekly hike in prices on record.
Hurricane Katrina affected 25% of U.S. crude oil production. It shut down between 10% and15% of refinery capacity for the first few days following the storm. It came on the heels of Hurricane Rita. The combined effects of the two storms reduced crude oil inputs into refineries to 11.7 million barrels per day during the week ended Sept. 30. It was the lowest average since March 1987.
Mississippi River Flooding
In May 2011, the Mississippi River flooding caused $2 billion in damage. Commodities traders were concerned the flooding would damage oil refineries. Fear of shortages sent gas prices up to $4.08 a gallon.
Surprisingly, oil spills don't cause higher prices. For example, the Exxon-Valdez oil spill spewed 11 million gallons (262,000 barrels) of oil. Although this had a devastating impact on the Alaskan coastline, it didn't really threaten world supply.
The BP oil spill spewed more than 12 times the oil than did the Exxon Valdez. Yet, oil and gas prices barely budged as a result. Why? For one thing, global demand was down thanks to a slow recovery from the 2008 financial crisis.
Second, even though 3.19 million barrels of oil was spilled, it was over three months. It also wasn't a large percentage of total oil used by the United States. In fact, it was only about nine days' worth of oil. The United States consumed 7 billion barrels in 2010, according to the U.S. Energy Information Administration. That's a little over 19 million barrels per day.
How World Crises Impact Oil Prices
Potential world crises in oil-producing countries dramatically increase oil prices. That's because traders worry the crisis will limit supply.
That happened in January 2012 after inspectors found more proof that Iran was closer to building nuclear weapons capabilities. The United States and the European Union began financial sanctions. Iran threatened to close the Strait of Hormuz. The United States responded with a promise to reopen the Strait with military force if necessary. The possibility of an Israeli strike was also a concern.
As a result, oil prices bounced around $95 to $100 a barrel from November through January. In mid-February, oil broke above $100 a barrel and stayed there. Gas prices also went to $3.50 a gallon. Forecasts were that gas would be at least $4 a gallon through the summer driving season.
World unrest also caused high oil prices in the spring of 2011. In March 2011, investors became concerned about unrest in Libya, Egypt, and Tunisia in what became known as the Arab Spring. Oil prices rose above $100 a barrel in early March and reached its peak of $113 a barrel in late April.
The Arab Spring revolts lasted through the summer and resulted in an overturn of dictators in those countries. At first, commodities traders were worried that the Arab Spring would disrupt oil supplies. But when that didn't happen, the price of oil returned to below $100 a barrel by mid-June.
Oil prices also increased $10 a barrel in July 2006 when the Israel-Lebanon war raised fears of a potential threat of war with Iran. Oil rose from its target of $70 a barrel in May to a record-high of $77 a barrel by late July. A review of the oil price history explains what makes oil prices so unpredictable.
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