What is driving crude oil prices

(Published June 24, 2015)

The price of crude oil reflects the delicate equilibrium between supply and demand factors that are at constant interplay on world markets. In classic economic terms, supply side actors (oil-extracting countries and companies) are willing to pump out more petroleum with the rise of its global price. In particular, this price is the ICE Brent benchmark that traders use, directly or indirectly, to set prices of around 60 to 70% of crude oil deliveries across the globe. Naturally, demand side players like oil-consuming nations, energy-intensive industries, and households (through the gasoline price) want to buy less crude while price increases last. Note, however, that there is some inelasticity, i.e. consumption will probably not drop quickly even in the event of sudden hikes of the oil price, for instance, because of higher seasonal demand.

In the end, supply side factors push prices up or down signaling further alteration of the global demand which in turn also contributes to price changes. Below we discuss some of the general factors influencing crude oil prices.

Supply side factors

Output and delivery depend on a number of determinants related to technology, international and domestic politics and, generally, on the security of supply.

- Technological breakthroughs like cutting-edge exploration techniques or enhanced oil extraction are significantly increasing the access to previously hard-to-get oil reserves. For example, shale deposits were long known to exist but their extraction became cost-effective only in the past 10 years with horizontal drilling and other production methods that are now wide-spread;

- Political decisions can sometimes be counter-intuitive to market logic. For instance, contrary to expectations for reductions in output, in June 2015 OPEC nations confirmed their 30 million bpd production target. Despite mounting losses from depressed oil prices, the 12 member countries of OPEC decided to defend their global market share against high-cost producers in North America;

- Violent upheavals (e.g. civil wars, military conflicts or revolts) create uncertainty and could lead sudden supply cut-offs and higher oil prices. For instance, the Libyan conflict of 2011 disrupted production and forced some oil-consuming nations to release petroleum from their strategic reserves in an effort to stabilize prices;

- Natural phenomena (hurricanes, earthquakes, etc.) can also negatively affect production and disrupt supply chains. Many observers know that, for example, strong hurricanes in the Gulf of Mexico sometimes cause damage to off-shore oil rigs and other extractive infrastructure in the region. As a result, oil prices are likely to rise.

Demand side factors

The willingness of consumers to purchase oil depends on the overall state of the economy as well as on individual disposable incomes of demand-side actors.

- Economic growth is by far the most important factor. As a rule of thumb, expanding economies need more energy to sustain the growth of their GDP. Conversely, periods of recession are usually associated with lower demand. Emerging economies, particularly China and India, are very hungry for energy. Hence, their economic growth will be of greater importance for the global oil demand. Moreover, many people in developing nations are expected to have their first cars which would lead to higher demand for petroleum products;

- Efficiency of consumption is becoming more important for political and corporate decision makers as it improves resilience to oil price shocks. While emerging economies are energy-intensive, developed countries from the OECD consume decreasing amounts of oil per unit of economic output. In other words, OECD economies will be more likely to decouple economic growth from oil consumption.

To hedge against volatile oil prices and any of the risks associated with the factors listed above, many businesses actively trade on the futures markets. Another way of managing oil price risks is to diversify away from petroleum and fossil fuels in general. As a complementary measure to energy efficiency, many companies plan to and are actually sourcing energy from renewable sources and biofuels.

Image by Pixabay

Historical prices of crude oil (1861 - 2014).

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