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What determines the Oil Prices


The oil prices impact the overall global economy, since it’s used as an energy resource for goods and services across the industries. The recent fall in the prices brought about the worst downturn in the oil and gas industry, the most consequential in a generation where around 44,000, 000 jobs were lost.

So, what is it that determines the prices of oil and shapes the economies, careers and lives of people.

The Primary Factors:

The principal causes that impact the prices are:
1) Supply and Demand
2) Market Sentiment

The factor of Supply and Demand is lucid to understand - demand is directly proportional to the oil prices. With the increase in demand - when production & supply is exceeded by demand the oil prices spike. On the decrease of demand - when it is out done by production, oil prices decrease.

The oil prices are set by commodities traders in the oil futures market. Oil futures contracts are agreements to purchase or sell oil at a specified date in future and at an agreed upon price. These traders are registered with Commodities Futures Trading Commission. While the commodities have been traded for over 100 years, they have been regulated by the CFTC since the 1920's.

Market sentiment is the overall approach of investors towards any commodity in the financial market. In simpler words it is the feeling, spirit and psychology of the market that is manifest in the pursuits and price movements. In general, high prices reflect bullish market sentiment, whereas falling prices mean that the market sentiment is bearish.

The commodities traders determine the oil prices based on a few aspects, which in natural consequences affect the market sentiment as well. And these factors are:

Current Market Supply - In the past, the supply from the market majorly determined by the quotas of the OPEC countries. However, a shale surge in US propelled by technological advances, created a glut in the market which caused the downturn.

If the current market supply is in excess, the traders set lower prices for the oil. A shortage in supply propel the prices determined in the futures contracts.

Future supply access- The traders also consider access to the oil reserves, that would supply the oil in the future. In the event when oil prices get too high, Saudi Arabia can easily tap its oil reserves to ensure continuous supply. Similarly, the availability of inventories in US reserves and Strategic Petroleum Reserves also determines the bids of the futures contracts.

Demand - And this basic factor in respect to its relation with supply has already been explained above.

In the events and happenings

If we look at this process of determination of oil prices more introspectively, the 3 major aspects- current supply, future reserves access and demand are fairly impacted by the political and natural events that happen around the world, both in oil producing nations as well as major consuming nations.

Turmoil in the oil producing nations or any indicative potential of it raise the prices of oil. This is because when bidding for the prices in futures contracts, traders are apprehensive of these events limiting the supply and so they bid higher prices to ensure that they have adequate supply.

In March 2011, the political unrest in Libya, Egypt and Tunisia, also known as the Arab Spring concerned the traders about the oil supplies. This resulted in the rise of oil prices to more than $100 a barrel which later spiked up to $113 towards the end of April.

While the Arab Spring lasted throughout the summer, the dictatorship rules were overturned, but the oil supplies did not suffer any disruption. As a result, the oil prices returned back to a price below $100 a barrel around mid-June period.

In 2006, when the Israel-Lebanon war raised fears of a possible war with Iran, oil prices went up by $10 a barrel.

The Cycle of Prices

By looking closely at the history of oil prices, a cyclical pattern in the prices can be traced. It appears that a cycle can be traced in an approximate period of 30 years. When the demand for oil began in the early 1900's significant spikes were seen in 1920, 1951 and 1980.

All in all, it is the supply, demand and the market sentiment that preside in determining the oil prices. However, it is general cyclical trend of the rise and fall of demand in the period of 30 years that tends to recur.

In general, the oil prices are determined by the supply, demand and sentiment towards the futures contracts. However these primary factors are significantly impacted by the events and crisis of the world as they affect the market sentiment on account of current or speculative alterations or altercations in demand and supply.

Legislations and policies of the major oil producing nations also effect the prices of oil. Most of the oil reserves and production units owned or controlled by state owned companies. Therefore, policies and orders issues by governments can have significant impacts. If governments enforce bans on oil exploration campaigns in significant reserves, then the market deems this as a limitation to the oil supply - due to the limit in access to future reserves. This apparent loss results in the increase of oil and gas prices.

Looking at the natural events of disaster, oil prices increased by $3/barrel in 2005 when oil producing areas of US were hit by Hurricane Katrina. This had been preceded by Hurricane Rita and the period between the two saw a destruction of 113 offshore oil and gas platforms along with severe damages to 457 oil and gas pipelines, thereby affecting 19% of the oil production in US.