Usually I eavesdrop on intense arguments between office colleagues, boss to employees, people at motor parks, students, lovers, oil investors, radicals even children on the cause of the dynamics in oil prices and trust me I have heard funny reasons for answers. Obviously someone doesn't just wake up and say "Oii today looks like a good day for low prices" neither is it some discount activity like the boxing day sales.
I promise not to get too technical and bore you with the economical brouhaha involved and to do that I have explained the phenomenon in lay man terms. (P.S: lay man terms is a relative word in this case).
First of all with each passing year crude oil continues to play an even greater role in the global economy. Annual capital expenditure on oil, gas and coal extraction, transportation and oil refining has surpassed $1 trillion as of date and with oil being the major player because of it's wide acceptability and efficiency a fluctuation in price will send some hard ripples through both producer and consumer nations. Crude oil prices are determined by 3 main factors: demand, supply and market sentiment. As demand increases (or supply decreases) the price should go up. As demand decreases (or supply increases) the price should go down. Sound simple?
Unlike most products, oil prices are not determined entirely by supply, demand and market sentiment toward the physical product. Rather, supply, demand and sentiment toward oil futures contracts, which are traded heavily by speculators, play a dominant role in price determination.
Oil prices are determined by commodities traders who bid on oil futures contracts in the commodities market. These contracts are agreements to buy or sell oil at a specific date in the future for an agreed-upon price. Commodities traders fall into two categories; the Hedgers and Speculators.
The hedgers are mostly 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 therefore reduce (or hedge) the risk to their corporations. Traders in the second category are actual speculators. Their only motive is to make money from changes in the price of oil by closely guessing the price direction and has no intention of buying the product.
Factors Traders Use To Determine Oil Prices
1. Current supply in terms of output. This is usually controlled by OPEC quotas. If the traders feel there is a glut of oil (as are the happenings today) they bid the price down. Depending on the cause of this glut suppliers might want to play safe in agreeing to a future contract price.
2. Access to future supply, which depends on oil reserves. This includes what's available in the refineries and other strategic petroleum reserves (proven reserves). The ease of market access to these reserves determines at what rate supply can be increased in a case of high prices.
3. Current demand from consumer nations. Traders usually look out for seasons. For example demand goes up during the summer season because of increased driving. Increasing demand in terms of shortage in supply is the major point referred to here.
Below are two illustrations on how the above factors work:
1. Iran Nuclear Crisis
This 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 Straits of Hormuz (reduce supply, increase demand). About 20% of the world's petroleum, and about 35% of the petroleum traded by sea, passes through the strait making it a highly important strategic location for international trade.
As a result, oil prices bounced around $95-$100 a barrel from November through January. In mid-February, oil broke above $100 a barrel and stayed there.
2. Natural Disasters
Natural and man-made disasters can drive up oil prices if they are dramatic enough. Hurricane Katrina caused oil prices to rise $3 a barrel, and gas prices to reach $5 a gallon in 2005. Katrina affected 19% of the nation's oil production. It came on the heels of Hurricane Rita. Between the two, 113 offshore oil and gas platforms were destroyed, and 457 oil and gas pipelines were damaged (access to future supply).
OPEC Basket Price for Crude Oil from 2003-current
In summary, the price of oil is determined by its price in the oil futures trading market. The price in this market is determined by traders who use the current supply, access to future supply and demand to bid in the issuance of these trade contracts. This is the easiest way I can explain it and in future posts we will look at in details the real dynamics to the oil price.
Feel free to add or subtract in the comment section below. Cheers
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