What Causes Oil Prices to Fluctuate?

Investing

Oil is a commodity, and as such, it tends to see larger fluctuations in price than more stable investments, such as stocks and bonds. There are several influences on oil prices, a few of which we will outline below.

Key Takeaways

  • Oil prices are influenced by a variety of factors, particularly the decisions about output made by producers like the Organization of Petroleum Exporting Countries (OPEC), independent petro-states like Russia, and private oil-producing firms like ExxonMobil.
  • Like any product, the laws of supply and demand influence prices.
  • Natural disasters that could potentially disrupt production, and political unrest in oil-producing countries all impact pricing.
  • Production costs influence prices, along with storage capacity.
  • Although less impactful, the direction of interest rates can also influence the price of commodities.

OPEC Influences Prices

OPEC, or the Organization of Petroleum Exporting Countries, is the main influencer of fluctuations in oil prices. OPEC is a consortium that, as of 2021, is made up of 13 countries: Algeria, Angola, Congo, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Saudi Arabia, the United Arab Emirates, and Venezuela.

According to 2018 statistics, OPEC controls almost 80% of the world’s supply of oil reserves. The consortium sets production levels to meet global demand and can influence the price of oil and gas by increasing or decreasing production.

Before 2014, OPEC vowed to keep the price of oil above $100 a barrel for the foreseeable future, but midway through that year, the price of oil began to tumble. It fell from a peak of above $100 a barrel to below $50 a barrel. OPEC was the major cause of cheap oil in that instance, as it refused to cut oil production, leading to the tumble in prices.

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Supply and Demand Impact

As with any commodity, stock, or bond, the laws of supply and demand cause oil prices to change. When supply exceeds demand, prices fall; the inverse is also true when demand outpaces supply.

The dramatic drop in oil prices in 2014 has been attributed to lower demand for oil in Europe and China, coupled with a steady supply of oil from OPEC. The excess supply of oil caused oil prices to fall sharply.

While supply and demand impact oil prices, it is actually oil futures that set the price of oil. A futures contract for oil is a binding agreement that gives a buyer the right to buy a barrel of oil at a set price in the future. As spelled out in the contract, the buyer and seller of the oil are required to complete the transaction on a specific date.

The COVID-19 Demand Shock of 2020

Oil futures markets were hit with a historical anomaly in April 2020, when the May WTI Crude futures contract fell to negative $40.32. One way of understanding how the futures contract could be negative is to understand that the cost of storing oil was, at that time, very high due to months of oversupply and the total lack of demand brought on by the COVID-19 pandemic.

Simultaneously, a dispute between OPEC member Saudi Arabia and Russia (not an OPEC member) led to a flood of supply hitting the market. President Trump tried to broker a deal to cut production, but it was not implemented in time to prop up oil prices.

Futures traders were willing to pay to offload their futures contracts so they would not have to take physical delivery of the oil. (There isn’t a lot of oil storage space in financial trading companies.)

The situation where near-term prices are lower than futures farther out is called contango, and news outlets called oil’s contango on April 20th a “super contango.” Usually, contango refers to a situation where arbitrageurs buy a commodity at its spot price and roll it into a futures contract at a higher price. But because so many traders were desperate to dump their May contracts—a situation probably made worse by oil exchange traded funds (ETFs) that automatically roll forward contracts—the market mechanism was overwhelmed.

Natural Disasters

Natural disasters are another factor that can cause oil prices to fluctuate. For example, when Hurricane Katrina struck the southern U.S. in 2005, affecting almost 20% of the U.S. oil supply, it caused the price per barrel of oil to rise by $13.  In May 2011, the flooding of the Mississippi River also led to oil price fluctuation.

The COVID-19 pandemic is another example of a natural disaster, but unlike nearly all other natural disasters that raise the price of oil by creating a supply shock, the COVID-19 disaster created a demand shock. Many flights—both international and domestic—were canceled on orders of governments to close borders. As a result, gasoline consumption in the U.S. fell off a cliff.

The United States consumes almost one-fourth of the world’s oil.

Consequently, gasoline refiners didn’t want to take oil that they couldn’t process for sale, and oil reserves began to pile up at the WTI storage facility in Cushing, Oklahoma (where oil is stored for delivery in the U.S). In response to the crisis, major oil producers sidelined production.

Political Instability

From a global perspective, political instability in the Middle East causes oil prices to fluctuate, as the region accounts for the lion’s share of the worldwide oil supply. For example, in July 2008, the price of a barrel of oil reached $128 due to the unrest and consumer fear about the wars in both Afghanistan and Iraq.

Production Costs and Storage

Production costs can cause oil prices to rise or fall as well. While oil in the Middle East is relatively cheap to extract, oil in Canada in Alberta’s oil sands is more costly. Once the supply of cheap oil is exhausted, the price could conceivably rise, if the only remaining oil is in the tar sands.

U.S. production also directly affects the price of oil. With so much oversupply in the industry, a decline in production decreases overall supply and increases prices.

In 2020, before the Coronavirus pandemic, the U.S. had an average daily production level of approximately 12.7 million barrels of oil. That average production, while volatile, can trend downward. Consistent weekly drops put upward pressure on oil prices as a result.

Oil diverted into storage has grown exponentially, and key hubs have seen their storage tanks filling up rather quickly. As of mid-April 2020, the storage hub at Cushing holds roughly 60 million barrels—with a total capacity of 76 million barrels.

More importantly, given the demand crisis created by the COVID-19 pandemic, the rate at which oil has filled up reserves prompted oil majors and oil-producing governments to slash production. In this unprecedented environment, the only winners are companies who store oil, including shipping companies with tankers who have been able to raise prices for oil storage.

Interest Rate Impact

While views are mixed, the reality is that oil prices and interest rates have some correlation between their movements. However, they are not tightly correlated. In truth, many factors affect the direction of both interest rates and oil prices. Sometimes those factors are related, sometimes they affect each other, and sometimes there’s no rhyme or reason to what happens.

One of the basic theories stipulates that increasing interest rates raise consumers’ and manufacturers’ costs, which reduces the amount of time and money people spend driving. Fewer people on the road translates to less demand for oil, which can cause oil prices to drop. In this instance, we’d call this an inverse correlation.

By this same theory, when interest rates drop, consumers and companies are able to borrow and spend money more freely, which drives up demand for oil. The greater the usage of oil, the more consumers bid up the price.

Another economic theory proposes that rising or high-interest rates help strengthen the dollar against other countries’ currencies. When the dollar is strong, American oil companies can buy more oil with every U.S. dollar spent, ultimately passing the savings on to consumers.

Likewise, when the value of the dollar is low against foreign currencies, the relative strength of U.S. dollars means buying less oil than before. This, of course, can contribute to oil becoming costlier to the U.S., which consumes 20% of the world’s oil.

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