What determines the price of oil?

Crude oil is the basis for many types of fuel. It is used in the production of gasoline, diesel and jet fuel. Besides its use as a fuel, crude oil is also used as a base for motor oils, fertilizers, asphalt and many other applications. When trading oil, it is always important to take into account OPEC, the major exporting countries and their political situation to determine the risks involved in the price. In the case of oil, the actions of a few countries have a huge effect on the price.

Price factors

The price of crude oil like all commodities, is generally based on the balance between supply and demand. There are some factors that can affect this balance.

Reserves

The crude oil reserves of countries and companies influence crude oil prices. Consider not only the reserves held by countries, but also the amount of crude oil that has yet to be discovered and extracted. Because of this uncertainty about the reserves, many speculators in the market will drive prices based on their expectations, without knowing the current state of supply.

Replacement goods

Due to the increasing demand for less polluting fuels and the more efficient production methods of alternative fuels, they are becoming an increasingly attractive substitute for crude oil. This increasing use of alternative fuels affects the demand for crude oil and thus the price of crude oil. Alternative fuels are also encouraged by various countries that provide tax incentives to drivers of vehicles that have a less harmful impact on the environment. In this way, the demand for alternative fuels increases, resulting in a decreasing demand for crude oils.

Supply and delivery

Due to the limited number of places where crude oil can be extracted, the number of suppliers is also limited. Therefore, supply can have a major impact on price. For example, the Middle East is a major exporter of crude oil, but due to the turmoil in this region, crude oil prices may rise. Because of their importance to overall supply, their declining production causes the balance between supply and demand to shift further apart. This results in a rising price. Apart from extraction, the refining capacity of the different refineries plays an important role in meeting demands. As demands increase rapidly, refineries may not be able to meet these high demands. This will result in a rising price due to the limited supply. There are different grades of oil and countries where these are produced under different conditions. Twelve nations that produce oil around the world make up OPEC (Organization of the Petroleum Exporting Countries). OPEC covers around 40% of global oil production. They influence the price of crude oil by limiting or increasing the amount they produce. The rule is: When supply decreases but demand remains high, supply becomes that much more valuable and expensive. Over the past five years, the supply of oil has increased dramatically outside OPEC countries – especially in the United States. In recent years, the US has transformed from one of the largest importers of energy to a major energy producer and net exporter. The main reason is fracking. “Fracking is the technology that made shale oil production profitable in the US,” says Johannes Benigni from research and consulting centre JBC Energy. New oil wells opened up, so supply has increased. Natural gas and crude oil production in the US has increased by 50% and 75% respectively since 2005, the consultant says. “It becomes more difficult to calculate the price because the supply no longer comes exclusively from OPEC, now other countries also have a strong influence. However, supply is also affected by the conditions under which oil is produced. The price of producing a barrel can vary between a few USD per barrel and up to USD 80. Government policies such as environmental regulations or difficult geographical conditions increase production costs. “Some of the most expensive barrels are those in difficult locations like the deep sea. Production in challenging geological formations also raises the price of supply,” says Johannes Benigni. “When demand is low and the oil price thus low, comparatively ‘expensive’ production no longer pays off. This then reduces supply, which affects oil prices.

The demand

The amount of oil needed also depends on global economic developments. Right now, the market is mainly driven by developments in Asia. Demand in China and India, for example, has risen sharply over the past two decades as their economies grow faster than Europe’s. An increase in population growth can also boost demand for energy – and therefore oil – in the long term. But the price of oil could fall despite a growing economy, because the price is also determined on the demand side by other factors such as taxation, weather and environmental regulations. The International Energy Agency (IEA) predicts in the current World Energy Outlook that energy demand in Europe will decrease slightly. We will also see changes due to an increasing demand for renewable energy.

Delivery date and place

The time and place of delivery of crude oil can affect the price. In the case of floating prices, the delivery date affects the price because the price is an average of reference prices. These prices can change over time and thus affect the eventual price. Location affects the price due to the use of marker crudes, which can vary depending on location. This results in a possible price difference. These factors will be explained in the following sections.

Pricing methods

There are different methods for pricing crude oil. Listed below are some of the more conventional pricing methods.

Markers

Markers act as a benchmark for the price of crude oils and their futures contracts. These crude oils can be used as a benchmark for the global market, but can also apply to a specific area. However, the use of crude oil is not mandatory. The prices of futures can be determined as a differential to crude oil.

Fixed price

A fixed price can be set in two ways. The first way is where a government sets a price for a period of time. This method can be used when the oil market in a country is nationalized. The second way is where the parties agree on a price for a period of time. This is a form of over-the-counter trading.

Floating price

Here the price is not fixed but is determined at the time of delivery. An average of the oil price around the time of delivery is thus set as the final price. Specialized companies analyse the market and set so-called reference prices, which are averages of a period’s price movement. In this way, contracts can be easily settled using these reference prices.

Stock exchanges

Crude oil is traded today on exchanges around the world, from NYMEX in New York to TOCOM in Japan. However, exchanges tend to be the last resort for large producers who sell their surplus oil through them. Many companies in the energy sector protect themselves against price fluctuations with financial market activities. Purely financial players then bet on price changes and try to make a profit that way. Psychological factors and expectations play a role here. In the short term, speculation on falling or rising prices may well determine price developments. But almost all studies show that there is no or only a temporary limited link between speculation and absolute price levels.

OPEC

Many of the largest oil-producing countries in the world are part of a cartel called the Organization of Petroleum Exporting Countries (OPEC). In 2016, OPEC allied with other non-OPEC oil-exporting countries to form an even more powerful entity called OPEC+ or OPEC Plus. The cartel’s aim is to exert control over the price of the precious fossil fuel known as crude oil. OPEC+ controls over 50% of global oil production and around 90% of proven oil reserves. This dominant position ensures that the coalition has a significant influence on oil prices, at least in the short term. In the long term, its ability to influence oil prices is diluted, mainly because individual countries have different incentives than OPEC+ as a whole.

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