Oil prices are heavily influenced by traders who bid on oil futures contracts in the commodities market based on their perceptions of the future supply and demand for oil. Futures contracts and oil derivatives are traded daily, which acts to influence the price of oil. This causes the price of oil to change daily because it all depends on how trading went that day.
Traders base their bids on their perceptions of supply and demand. Other entities, such as governments and the Organization of the Petroleum Exporting Countries (OPEC), can affect the traders' bidding decisions by influencing trade or adjusting the amount of oil produced and stored.
Oil is commonly referred to as being the most volatile of commodities. If you are considering trading in oil or oil derivatives, it helps to understand what factors drive the price of oil and how traders, governments, and consumers influence it.
- Traders heavily influence oil prices through bids on futures contracts
- Bids are based on perceptions of current and future global supply and demand
- Man-made and natural crises make huge impacts on oil prices
Traders Are Major Oil Price Influencers
Oil futures contracts are executed on the floor of a commodity exchange, where only commodities are traded. The Chicago and New York Mercantile Exchanges are two of the more well-known commodity exchanges.
U.S. commodities have been traded for more than 150 years. Traders must be registered with the Commodities Futures Trading Commission (CFTC), which has regulated commodity traders since the 1920s.
Oil futures contracts are agreements to buy or sell oil at a specific date in the future for an agreed-upon price. Oil derivatives are securities that are based on the underlying price of oil and traded on the exchanges.
Commodities traders fall into two categories: hedgers and speculators.
Hedgers are representatives of companies that produce or consume oil. Hedging allows them to know the price of the oil and can plan for it financially. The contracts set the price for the buyer and seller, reducing risk for their companies when prices rise and fall.
Traders in the second category are speculators. Their only motive is to make money from changes in the price of oil. Futures speculators are generally the ones that are interested in oil derivatives, trading on small incremental changes in prices.
Three Factors Traders Use To Determine Oil Prices
There are three main factors that commodities traders look at when developing the bids that influence oil prices. These are the current supply, future supply, and expected demand.
The current supply is the total world output of oil. OPEC produces about 40% of the world's oil crude oil and thus has a controlling say in world oil prices.
Between January 2011 and December 2014, the U.S. shale oil production quintupled from one million to around 4.8 million barrels per day (b/d). This increase in production created an oil glut—which means there was more oil in production than in demand. The U.S. oil production increase sent the price of imported crude oil down to around $27 per barrel (/b) in February 2016.
By late 2019, shale oil production eclipsed 8 million b/d, and per-barrel oil prices averaged around $58 for the year. Production fell to 10 million b/d by May 2020, rose to 11 million in July, and remained between 10 and 11 million through October. Production was over 11 million from November 2020 through January 2021 and dipped to 9.8 million b/d in February 2021. U.S. crude production increased to 11.2 million b/d in May 2021.
West Texas Intermediate (WTI) oil prices averaged around $39/b in 2020 and, according to the U.S. Department of Energy's Short-Term Energy Outlook, are expected to average around $66/b in 2021 and $62/b in 2022.
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, if natural disasters reduce the flow of oil into the U.S., or if there is otherwise a need for oil, based on criteria in the Energy Policy and Conservation Act of 1975.
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 driving season and falls in the winter. To predict demand, forecasts for travel from AAA are used to determine potential gasoline use in the summer, whereas weather forecasts are used in the winter.
The oil price forecast has shown 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. Recently, pandemics and natural disasters have wreaked havoc on oil prices.
COVID-19 Coronavirus Pandemic
In January 2020, many governments began restricting travel and closing businesses to stem the coronavirus pandemic. As a result, demand for oil began falling. In the first quarter of 2020, oil consumption averaged 94.4 million b/d, down 5.6 million b/d from the prior year.
A drop in demand was worsened by the supply glut. On March 6, 2020, Russia announced it would increase production in April 2020. To maintain its market share, OPEC announced it would also increase production.
As storage facilities filled, prices plummeted into negative territory. On April 12, 2020, OPEC and Russia agreed to lower output to support prices. This action still wasn't enough to convince traders that supply wouldn't outpace demand, and the price of oil continued downhill. By April 20, 2020, the price for a barrel of WTI at Cushing in the U.S. had fallen to around -$37.
However, WTI prices rebounded by the first week of June 2020, climbing to $39/b by June 5 and surging to $40 in the last week of July. Prices have continued to steadily increase through 2020 and into 2021, fluctuating between $75/b in July and $62/b in August.
Internationally, Brent crude oil prices averaged $42/b in 2020 and are projected to average $69/b in 2021 and $66/b in 2022. Brent crude prices averaged $71/b in August 2021.
Mississippi River Flooding
In May 2011, the Mississippi River flooding caused at least $2 billion in damage. Commodities traders were concerned the flooding would damage oil refineries—fear of shortages sent gas prices up to $4.02 a gallon by the second week of the month.
Hurricane Katrina was a Category 5 hurricane that hit Louisiana on Aug. 25, 2005. Between August 29 and September 5, the U.S. average price for regular gasoline rose $0.46 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% and 15% of refinery capacity for the first few days following the storm. One month later, Hurricane Rita impacted the Gulf states. Combined, the effects of the two storms reduced crude oil refinery inputs 11.7 million b/d during the week that ended September 30. This was the lowest average output since March 1987.
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 threaten the world's oil supply or prices.
The BP oil spill spewed 12 times the oil than the Exxon Valdez did, per barrel. Yet, oil and gas prices barely budged as a result. Why? First, global demand was down thanks to a slow recovery from the 2008 financial crisis.
Second, even though nearly 134 million gallons or 3.2 million barrels of oil spilled, it was over a period of around three months. While this is a large amount of oil, it isn't very much when the percentage of the total oil used by the United States is considered. The United States consumed 7.5 billion barrels in 2019, according to the U.S. Energy Information Administration—a little over 20.5 million b/d or the equivalent of over six BP oil spills.
In 2020, the U.S. consumed 18.1 million b/d of oil, the lowest since 1995.
How World Crises Impact Oil Prices
World crises in oil-producing countries, or concern about crises, dramatically increase oil prices. This is because traders worry the crisis will limit oil supply, which increases demand and prices.
This is exactly what 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 responded by threatening to close the Strait of Hormuz (a major oil shipping lane). The United States responded with a promise to reopen the Strait with military force if necessary.
Oil prices for WTI at Cushing in the U.S. averaged from $97/b in November 2011 to $100/b in January 2012. In February 2012, oil broke $108/b and remained above $100/b through April. Gas prices also topped $3.50 a gallon that month.
World unrest also causes high oil prices. In March 2011, investors became concerned about unrest in several countries, including Libya, Egypt, and Tunisia (called the Arab Spring). As a result, oil prices rose above $100/b in early March and peaked at around $113/b in late April.
Oil prices also increased in mid-2006 when the Israel-Lebanon war raised fears of a potential threat of war with Iran. Oil rose from around $71/b in May to a record-high (at the time) of nearly $77/b by mid-July.