Crude oil prices are determined by global supply and demand. Economic growth is the biggest factor that affects demand—growing economies require energy. The petroleum products made from crude oil and other hydrocarbon liquids account for about a third of total world energy consumption.
Seasonal changes in demand for petroleum products can influence the supply and demand balance for crude oil and its market price. For example, crude oil markets tend to be stronger in the fourth quarter of the year—when global demand for heating oil is boosted both by cold weather and by inventory building—and weaker in late winter as demand for heating oil falls with warmer weather.
OPEC can influence world oil supplies and prices
The Organization of the Petroleum Exporting Countries (OPEC) can have a significant influence on prices by setting production targets for its members. OPEC includes some of the world's most oil-rich countries. Together, these countries control about 73% of the world's total proved oil reserves, and in 2016, they produced 44% of the world's total crude oil.
OPEC attempts to manage the oil production of its member countries by setting crude oil output targets, or quotas, for each member (except for Iraq, which does not have a current target). Compliance of member countries with OPEC quotas is mixed because production decisions are ultimately in the hands of the individual countries.
In general, three main factors determine how effectively OPEC can influence oil prices:
- How unwilling or unable consumers are to move away from using oil
- How competitive non-OPEC producers become when oil prices change
- How efficiently OPEC producers can supply oil compared with non-OPEC producers
The difference between market demand and supply from non-OPEC sources is often referred to as the call on OPEC.
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The U.S. Energy Information Administration (EIA) defines spare capacity as the volume of oil production that can be brought online within 30 days and sustained for at least 90 days. Spare capacity can also be thought of as the difference between a country's current oil production and its maximum oil production capacity. If a supply disruption occurs, oil producers can use spare capacity to moderate increases in world oil prices by boosting production to offset reduced oil supplies.
OPEC also maintains the world's entire spare crude oil production capacity. Saudi Arabia, the largest oil producer within OPEC and one of the world's largest oil exporters, historically has had the largest share of the world's spare production capacity. Developing and maintaining idle spare production capacity is generally not cost-effective for international oil companies (IOC) because the IOC business model maximizes revenue by producing oil as long as the price of selling the oil is higher than the cost of getting an additional barrel of oil to market. OPEC spare capacity provides an indicator of the world oil market's ability to respond to potential crises that reduce oil supplies.
Causes of world crude oil prices and supply disruptions
Geopolitical events and severe weather that disrupt the supply of crude oil and petroleum products to market can affect crude oil and petroleum product prices. These events may create uncertainty about future supply or demand, which can lead to higher volatility in prices. The volatility of oil prices is tied to the low responsiveness, or inelasticity, of supply and demand to price changes in the short term. Crude oil production capacity and the equipment that uses petroleum products as its main source of energy are relatively fixed in the near term. It takes years to develop new supply sources or to vary production, and when prices rise, switching to other fuels or increasing equipment fuel efficiency in the near term is hard for consumers to do. These conditions may require a large price change to rebalance physical supply and demand.
Most of the crude oil reserves in the world are located in regions that have been prone to political upheaval or in regions that have had oil production disruptions because of political events. Several major oil price shocks have occurred at the same time that political events caused supply disruptions, most notably the Arab Oil Embargo in 1973–74, the Iranian revolution, the Iran-Iraq war in the 1980s, and the Persian Gulf War in 1990–91. More recently, political events in Iraq, Libya, Nigeria, Syria, and Venezuela have contributed to supply disruptions.
Given the history of oil supply disruptions caused by political events, market participants constantly assess the possibility of future disruptions. In addition to the size and duration of a potential disruption, market participants also consider the availability of crude oil stocks and the ability of other producers to offset a potential supply loss. When spare capacity and inventories are low, a potential supply disruption may have a greater impact on prices than might be expected if only current demand and supply were considered.
Weather also plays a significant role in the supply of crude oil. Hurricanes in the Gulf of Mexico can affect oil production and refinery operations in the Gulf region. As a result, U.S. petroleum product prices may increase sharply as supplies from the Gulf to other regions drop. Severe cold weather can also strain product markets as producers attempt to supply enough of the product, such as heating oil, to consumers in a short amount of time to meet demand. This seasonal demand can also result in higher prices.
Other events such as refinery outages or pipeline problems can also restrict the flow of crude oil and petroleum products to market. These events can lead to a temporary supply disruption that could increase prices.
The influence of any of these factors on crude oil prices tends to be relatively short lived. Once the supply disruption subsides, oil and product flows return to normal, and prices usually return to their previous levels.
Buyers and sellers at a global auction
Crude oil and petroleum product prices are the result of thousands of transactions taking place simultaneously around the world at all levels of the supply chain, from the crude oil producer to the individual consumer. Oil markets are essentially a global auction—the highest bidder will win the available supply.
Like any auction, the bidder doesn't want to pay too much. When markets are tight (when demand is high and/or available supply is low), the bidder must be willing to pay a higher premium. When markets are loose (demand is low and/or available supply is high), a bidder may choose not to outbid competitors, waiting instead for lower-priced supplies.
Different types of oil market transactions are available
Contract arrangements in the oil market cover most crude oil that changes hands. Crude oil is traded in the futures markets. A futures contract is a standard contract to buy or sell a specific commodity of standardized quality at a certain date in the future. If oil producers want to sell oil in the future, they can lock in their desired price by selling a futures contract today. Alternatively, if consumers need to buy crude oil in the future, they can guarantee the price they will pay at a future date by buying a futures contract. In addition to oil producers and consumers, futures contracts are also bought and sold by market participants or speculators who do not produce or consume crude oil. These types of traders buy and sell futures contracts in anticipation of price changes, hoping to make a profit from those changes.
Crude oil is also sold in spot transactions, or an on the spot purchase of a single shipment for immediate delivery at the current market price.
Changes in prices send signals to the market
Prices in spot markets send a clear signal about the balance of supply and demand. Rising prices indicate that additional supply is needed, and falling prices indicate there is too much supply for current demand. Futures markets also provide information about the physical supply and demand balance as well as the market's expectations.