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 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
- Human-made and natural crises have 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 crude oil and thus has a huge impact on determining the world's 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 had eclipsed 12 million b/d, and per-barrel oil prices averaged around $57 for the year. Production fell to 11.28 million b/d for 2020. By the end of 2021, production fell at 11.16 million b/d for the year. Forecasts predict an increase in production for 2022, up to 12.01 million b/d.
West Texas Intermediate (WTI) oil prices averaged around $68.21/b in 2021, according to the U.S. Department of Energy's Short-Term Energy Outlook. Prices are expected to average around $97.96/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 the 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. Gasoline 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 human-made disasters can impact oil prices if they are dramatic enough. Recently, pandemics and natural disasters have wreaked havoc on oil prices.
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. Even before Russia's invasion of Ukraine in early 2022 caused prices to skyrocket, crude oil was on the rise. Prices continued to steadily increase through 2020 and into 2021, reaching $85.64/b on October 25, 2021—a high that hadn't been seen since October 2014.
Internationally, Brent crude oil prices averaged $42/b in 2020 and $71/b in 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 Sept. 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 that 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 18.12 million b/d of oil, the lowest since 1995. U.S. oil consumption was higher in 2021 at 19.78 million b/d.
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.
In February 2022, despite efforts from leaders in the U.S. and Europe to convince Vladimir Putin otherwise, Russia invaded the neighboring nation of Ukraine. As Russia's assault on Ukraine continued, so did the steady rise of crude oil prices. Prices surpassed $100 per barrel for the first time since 2014.
The surge in prices was caused by fears about supply issues. According to the IEA, Russia is the world's largest oil exporter. In March 2022, the U.S. announced its decision to ban imports of Russian oil. Shortly after, crude oil reached nearly $130/b. In order to combat supply issues, the U.S. and other member countries of the IEA announced they would be releasing a collective 60 million barrels from the strategic petroleum reserves. Still, the uncertainty surrounding how long the conflict will last as well as how the geopolitical landscape may be shook up by the war kept the price of crude oil well above $100 per barrel as the conflict continued into early April.
Frequently Asked Questions (FAQs)
What affects the price of oil?
The price of oil fluctuates according to three main factors: current supply, future supply, and expected global demand. Members of OPEC control 40% of the world's oil. Thus, many types of events that impact either the supply of oil (such as Russia's invasion of Ukraine in February 2022) or its expected demand (like the COVID-19 pandemic) will cause the price of oil to rise or fall.
Why did the price of oil go up?
After Russia, one of the top producers and exporters of oil in the world, invaded Ukraine in February 2022, oil prices rose to their highest levels since 2014. Russia was hit with a number of sanctions from the international community, causing future supply to decrease.
What is the price of crude oil?
As of April 2022, crude oil was trading at an average of $104 per barrel.