Factors Affecting Oil Prices
How the Price of Oil is Determined
Most of us have seen the headlines about major spikes and at times, steep drops in crude oil prices. While the daily shifts may seem like a mystery to many people, there are actually a complex set of interconnected factors that ultimately help to decide price. It is not uncommon to see news stories reporting that the price of oil is too high or too low with the author explaining why he or she holds that particular opinion.
The truth is that in a free market system absent of price controls, the "correct" price at any given time is the most recent level at which a buyer and seller match up to create a transaction. According to the CME Group, this takes place well over 500,000 times in an average trading day.
Factors Influencing Crude Oil Prices
Most people are familiar with the concept of supply and demand and have a basic understanding of how it works. Rapidly growing fuel demand from China, India and Brazil has been and continues as a driving force behind the price appreciation seen in recent years. These three countries with a combined population of 2.7 billion people have developed what some have called an insatiable appetite for crude oil.
To illustrate the tremendous influence these countries exert, China's fuel consumption increased by a staggering 12 percent in 2010 alone. Meanwhile, oil production in some of the world's largest oil-producing countries such as Saudi Arabia has fallen. Some industry insiders have speculated that the Saudis are pulling back after publicly overstating their reserves. Others believe that they may simply be accepting higher prices in the short-term to avoid a revolution similar to what has taken place in Libya. If this scenario plays out, part of the current production shortfall will be temporary. Regardless of the reasons behind it, fluctuations in supply have a large impact on pricing.
Another major role player in crude oil prices is the stability or lack thereof in countries in the Middle East. Since a large percentage of the global petroleum supply originates from somewhere in the Arabian Peninsula, any political instability in the region has the potential to cause supply disruptions. There mere potential for a problem to develop in the immediate future is often enough to send shock waves through the futures market.
Throughout history, as wars and revolutions swept across the Middle East, petroleum production has been vulnerable and in many cases fell by more than 50% during times of upheaval. Ongoing uncertainty about the region continues to push up prices as the "Arab Spring" continues to evolve. Despite efforts to diversify the geographic origins of crude, oil prices today remain highly dependent on political stability this vital region.
The Currency Connection
Since the world uses the United States dollar as a reserve currency, commodities such as crude oil trade in dollars on the global market. A falling weakening dollar can keep more money in the U.S. economy by making exports more attractive and imports less attractive but it can also drive up the price of oil as it takes more dollars to buy the same amount of crude. In recent years, the United States government has adopted an unofficial policy bias towards a weaker dollar and the impact can clearly be seen in the commodity markets.
How Seasonality Impacts Oil Prices
There are certain times of the year where predictable shifts in demand are known to occur. The EIA estimates that good weather and vacations cause U.S. summer gasoline demand to rise 5 percent higher than during the rest of the year.
Better weather means more vacations, which means more gasoline use. Think of it as a naturally occurring demand enhancer. In addition to the impact of summer vacation, this time of year also correlates to the annual hurricane season in the Atlantic Ocean and Gulf of Mexico. Inclement weather in these vital shipping lanes can cause supply disruptions and even temporarily stop off-shore drilling operations.
The Impact of Speculation
The general consensus is that this is one influence the media tends to dwell on and in many cases has overblown. With that being said, in the age of electronic trading where vast quantities of inventory can change hands in a millisecond with the click of a button or an algorithmic trade, it is a potential cause worth discussing.
Oil speculation can involve not only investors betting on the price of oil in the futures market but also gigantic financial institutions pumping millions of dollars in capital into the market to profit from anticipated trends. Many of these institutions never take delivery of a single drop of oil making them the source of growing controversy. This is especially true during times of exceptional volatility or rapidly rising prices.
Production and Development
The argument for increasing domestic production to ease tightening supplies has circulated for decades in the United States. Unfortunately, the fact remains that the market for petroleum is now global and the size of the U.S. reserve is much too small to impact worldwide prices. A large percentage of the world reserves eligible for cost-effective extraction are in areas beyond our immediate reach and are already being used in some capacity.
Even in areas where production could theoretically be increased, OPEC places strict controls on the available supply of crude oil. This group of producers jointly determines how much output will take place during specified periods of time. Due to the large percentage of the total global supply that falls within their control, their decisions can have a big impact on price trends.
Ultimately, the world must accept the fact that an energy source with a finite supply is insufficient to meet the constantly growing worldwide demand for fuel. This will eventually lead to the development and exploration of alternative energy sources and the technology needed to put them into production. Until that takes place, the intertwined set of factors discussed above will continue to shift the price of oil in an upward trend.
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