Determination of Oil Price
Did you ever wonder how the price of oil is determined? Oil price movement is the in-vogue topics as a consequence of the Russian invasion of Ukraine and the ongoing inflation of prices in countries like India. It is a testament to the importance of oil that, despite continued efforts to reduce its use and to find alternative green energy sources, oil remains one of the most in-demand commodities globally. Rising oil prices is also an indicator of simultaneous price rise of daily essentials like fruits, wheat, vegetables etc. So, price determination of oil is crucial and it has the potential to affect the global economy. This blog will dive deeper in this regard.
Primary factors that impact oil price
With oil’s stature as a high-demand global commodity comes the possibility that major fluctuations in price can have a significant economic impact. The two primary factors that impact the price of oil are:
- Supply and demand
- Market sentiment
The concept of supply and demand is as follows: As demand increases (or supply decreases) the price should go up and as demand decreases (or supply increases) the price should go down. The price of oil as we know it is actually set in the oil futures market. An oil futures contract is a binding agreement that gives one the right to purchase oil by the barrel at a predefined price on a predefined date in the future. Under a futures contract, both the buyer and the seller are obligated to fulfill their side of the transaction on the specified date.
The other key factor in determining oil prices is sentiment. Similar to stocks, the mere belief that demand for oil will increase dramatically at some point in the future can result in a dramatic increase in oil prices in the present, as speculators and hedgers alike snap up oil futures contracts. Of course, the opposite is also true. The market sentiment that oil demand will decrease at some point in the future can result in a dramatic decrease in prices in the present as oil futures contracts are sold (possibly sold short as well), which means that prices can hinge on little more than market psychology.
Oil Price Economics Variations
Basic supply and demand theory states that the more a product is produced, the more cheaply it should sell, all things being equal. If someone were to invent a well stimulation technique that could double an oil field’s output for only a small incremental cost, then with demand staying static, prices should fall. Actually, there have been periods of time when supply has increased. Oil production in North America was at an all-time zenith in 2019, with fields in North Dakota and Alberta producing large quantities of oil. Since the internal combustion engine still predominates on American roads, and demand hasn’t kept up with supply, it is expected that the price of oil was low at that point in time. However, a completely different situation gave rise in this scenario. Production was high with oil being stored in pressure vessels, but distribution and refinement were not able to keep up with it. Hence, the price of oil did not fall as much as was expected. This is because refineries operate at 90% of capacity; the excess capacity is there to meet future oil demand.
Final Thoughts
As discussed, the factors around determining oil prices are manifold and at times, they may cause well-known economics to become redundant. Considering the number of financial and geopolitical factors at play, guessing or “timing” oil prices in advance is difficult; however there have been cases where oil and gas prices have been manipulated. As the world becomes more inter-connected, oil prices become more ubiquitous in our lives – from the oil price at the local gas station to the prices displayed on financial indices!