Oil prices: What factors influence the value of oil?

Global oil prices are determined by the forces of supply and demand, according to the model of price determination in microeconomics. Supply is controlled by the production rate of the raw material while demand is highly dependent on global macroeconomic conditions.

However, oil markets themselves are not typically composed, as they once were, of individuals who need to buy or sell the raw material to make their refineries or factories turn a profit. In fact, the majority of people involved in the market are speculators and traders who are betting on price moves, and hedgers already active in the oil market who are limiting exposure risk.

As a result, oil prices are frequently heavily influenced by those traders’ perceptions of the future supply and demand of oil. This is not unusual in modern financial markets: consider how a company’s stock might start falling even on the same day that it posts impressive results.

This may be because investors may have expected those impressive results and are instead looking at future factors that may impact that company’s long-term performance. Exactly the same principle applies to oil, whereby expected future supply and demand factors tend to influence current pricing.

Oil is frequently regarded as one of the most volatile of commodities, but it is also one of the most economically mature. Major geopolitical events and natural crises can trigger major price swings, but on a day-to-day basis traders are still basing their bids on their perceptions of supply and demand.

What factors influence 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.

Oil supply is dictated to an extent by the well-known cartel of major oil-producing nations, OPEC. This is an intergovernmental consortium of 13 nations, founded in 1960 by its first five members (Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela).

According to data collected by Statista in September 2020, OPEC’s share of global crude oil reserves sits at 79.1%.

Why should traders watch OPEC closely?

Oil traders need to keep a close eye on OPEC’s supply volume, which is constantly adjusted in response to a range of factors. It is in the interests of OPEC to try to keep the price of oil relatively high in order to maximise profitability.

To achieve this, it will on occasion cut the supply of oil so prices rise. This is a strategic tactic that needs to be carefully deployed because a long-term reduction in supply would mean reduced revenues for OPEC’s member countries.

Many successful oil traders will seek to anticipate cuts in supply rather than react to them after the event.

History of oil price: 1999 onward

From 1999 to 2008, crude oil rose from under $25 per barrel to more than $160 per barrel as thriving economies like China and India drove an increase in demand.

This period was followed by a severe recession, sparked by the financial crisis of 2007-08. A key by-product was diminished demand for energy, and oil prices moved steeply downwards.

The recovery was swift, with prices jumping 78% in 2009 and continuing to rise in each of the next two years. That  made it economically viable for shale oil to be exploited.

What happens when there is over-supply of oil?

When there is an oversupply of oil, prices fall. For example, between 2011 and 2014, US shale oil production multiplied by a factor of five to around 4.8 million barrels per day.

This increase in production was enough to create an oil glut with production outstripping demand. In 2014, the price of oil tumbled by 46% and it fell by a further 31% the following year. But these dramatic falls were not purely caused by the rise in US shale oil production.

What factors contributed to the 2014 oil glut?

A significant factor that contributed to the 2014 oil glut was the stronger US dollar that followed the US Federal Reserve's decision to cut back on quantitative easing measures. This in turn built price pressure on a wide range of commodities.

In China, where rapid industrialisation in the first 10 years of the millennium had prompted year-on-year industrial growth, output began to slow after 2010, thus diminishing its requirement for oil.

Equally significant were the actions of OPEC member Saudi Arabia, holding one of the world’s biggest oil reserves. The nation was torn between letting prices continue to drop or ceding market share by cutting production in a bid to increase prices.

Saudi Arabia elected to maintain stable production, with the view that it was more important to weather the storm in the short term, accepting lower prices, than give up its healthy share of the market.

Prices fell to below $30 a barrel in 2016 having been above $100 a barrel two years earlier. Finally, OPEC did cut production and worked on an agreement with non-OPEC nations to try to reduce supply across the board to meet global demands more accurately.

After crude prices finally bounced off the bottom, North American oil companies were emboldened to increase investments in new wells. Whiting Petroleum, for example, signed several well participation agreements with financial partners, while Canadian Natural Resources took advantage of rising prices to restart its heavy oil drilling program.

From mid-2016 to the beginning of 2020, oil traded largely between $50 and $70 a barrel, though there remained plenty of volatility within that band.

How did oil hit prices turn negative in 2020?

In January 2020, many governments began restricting travel and closing businesses to stem the coronavirus pandemic. Consequently, demand for oil fell steeply and the oil futures market was spooked.

A drop in demand was accompanied by a supply glut. In March, Russia surprised the markets by announcing it would actually increase production in April even as world consumption fell sharply. To maintain its market share, OPEC announced it would also increase production.

As storage facilities filled, prices plummeted into negative territory for the first time in history. Oil producers were effectively paying buyers to take the commodity off their hands over fears storage capacity could run out in May.

Some companies even resorted to renting tankers to store surplus supply. Finally, OPEC and Russia jointly agreed to drop production, global economies saw lockdown restrictions eased and prices soon returned to something approaching normality.

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