What Determines The Oil Price?

It is not that difficult to understand the commodities market, such as oil. It can be easily & effectively explained using simple demand-supply diagram analysis. The prices of oil will increase if there is strong demand or cutback in supply (or both). Its prices will fall, like now when the demand sets back & there is overproduction in the market

Demand factor

(1) Period. During the winter, demand for oil will increase for heating purposes. The same goes for summer holiday, where most people will be travelling around. These 2 drive the oil price up

(2) Economic growth. Oil price is strongly correlated with level of economic growth. In the period of boom, oil price will normally skyrocket as there is a strong demand for it to fuel the industrial activities. There will be more flights for meetings, more trucks delivering goods, more people doing sales thus more cars on the road & more factories operating. The rise in oil price is also exacerbated by the rapid economic expansion in China & India, which records an average 8-10% of annual economic growth in the last few years

(3) Decision to pile up. The extent of oil price increase will also depends on how much oil those large economies such as US, China & India decide set aside for their reserves. US had long established its own oil reserves, while China has come up with 4 strategic reserves centres at coastal areas of Zhenhai, Zhousan, Dalian & Huangdao. It will start operating this month. Meanwhile India is also in the midst of constructing its storage centre this year, with its first centre in Visakhapatnam. Its 2 upcoming oil reserves will be in Mangalore & Podur.

Countries want to have their own reserves as an insurance against war & other external shocks. In such period they can reduce their reliability on imported oil & release it from their own reserves. Also it may reduce the risk of cost-push inflation onto their economy

(4) Futures traders. The price of oil is actually set in the oil futures market. Futures is a binding contract that gives one the right to purchase oil at a predetermined price & predetermined date in the future. 2 popular traders of futures are speculators & hedgers. Speculators have no intention of buying the product, but merely guessing the direction of the price to profit from it. Unfortunately, these speculators are the major driver of oil prices in the market, driving the oil price to as high as $147 in July. Hedgers are like airline firms buying oil futures to safeguard against any rising prices that may jeopardise their operations

Financial institutions are also on the increasing extent treated oil contracts like investment in shares or currencies. They buy these oil contracts in the hope their value will go up before selling them. Alternatively, if they think that its price will fall, they will sell oil contracts they don’t own (short sell) & buy them later to profit from the difference

(5) Strength US dollar. All commodities such as oil, steel, gold, palladium, aluminium & tin are traded in the value of greenback. Therefore as value of dollar weakens against other currencies, it means relatively cheaper to buy oil. Demand for oil will increase & this will naturally push the oil price higher. Also the dollar may rebound later since there will be greater need for dollar to facilitate the transaction. Its value also depends on many other factors for e.g. level of interest rates in US

Supply factor

(1) OPEC’s role. OPEC (Organisation of Petroleum Exporting Countries) controls 55% of the world oil exports. If the world oil price is on the downward pressure it may jeopardise the revenue for some of its members such as Iran & Nigeria, which economies are less diversified. These 2 are also known as the price-hawk for their aggressive stance in lobbying for higher oil price. Therefore, to safeguard their interest, they have the tendency to cut production. As supply falls back, price will increase

(2) Non-OPEC’s role. Much attention were given to OPEC members, without realising that non-OPEC oil producers such as Russia, Oman, Norway & Mexico have the potential to influence the world oil price. Even if OPEC decided to cut back the supply of oil to raise its price, it will not be successful if on the other hand, these countries raise their production. For instance, in 2001 OPEC’s effort to push up oil price failed when Oman & Russia increased oil production heavily

(3) Weather. Unpredictable weather, such as Tropical Storm Gustav, hurricane Katrina & Rita had the potential of disrupting oil production. For instance it may damage the oil platforms, refining networks, pipelines etc. If it does, there will be a fall of supply in the market, thus driving the price up. As a matter of fact, much of this has to do with “self-fulfilling prophecy”. Oil traders “will want to believe” that this will happen, therefore driving the demand & therefore oil price

(4) Violence against producers. Lots of the world’s oil unfortunately comes from politically unstable countries such as Nigeria & Iraq. For instance, somewhere June this year, some militants had launched an attack at Bonga oil platform where Shell is operating, thus causing it to stop operating temporarily. As supply falls, oil price increased for that day

(5) Level of investment. Depending on the market price for oil. If the oil price is high, oil companies will generate greater supernormal profit which can be then reinvested onto their operations. These include R&D activities, exploration of new oil deposits, setting oil platforms, pipelines etc which actually costs billions of dollars. In the long run, once oil infrastructures were set up, producers will be able to be more responsive to market demand. Any shortage in demand can be met by increasing the supply of oil, thus stabilising the world oil price

The ultimate determinant of oil price will actually be the interaction between the demand & supply curve. Depends on which shifts more. For instance, the current world oil price lingering around $51 is said to be due to demand falling faster than the supply