Crude oil prices are determined by global supply and demand. Economic growth is one of the biggest factors affecting petroleum product—and therefore crude oil—demand. Growing economies increase demand for energy in general and especially for transporting goods and materials from producers to consumers. The world’s transportation sector is almost totally dependent on petroleum products such as gasoline and diesel fuel. Many countries also rely heavily on petroleum fuels for heating, cooking, or generating electricity. Petroleum products made from crude oil and other hydrocarbon liquids account for about a third of total world energy consumption.
OPEC can influence world oil supplies and prices
The Organization of the Petroleum Exporting Countries (OPEC) can have a significant influence on oil prices by setting production targets for its members. OPEC includes countries with some of the world's largest oil reserves. As of the end of 2018, OPEC members controlled about 72% of total world proved oil reserves, and in 2018, they accounted for 41% of total world crude oil production.
OPEC attempts to manage oil production of its member countries by setting crude oil production targets, or quotas, for its members. Compliance of OPEC members with OPEC quotas is mixed because production decisions are ultimately in the hands of the individual members.
In general, the main factors determining OPEC's effectiveness in influencing oil prices include
- The extent to which OPEC members actually comply with production quotas
- The ability or willingness of consumers to reduce petroleum consumption
- The competitiveness of non-OPEC producers when oil prices change
- The efficiency of OPEC producers to supply oil compared with non-OPEC producers
The difference between oil market demand and supply from non-OPEC sources is often referred to as the call on OPEC because OPEC members maintain the world's entire spare crude oil production capacity. Saudi Arabia, the largest OPEC oil producer and one of the world's largest oil exporters, historically has had the largest share of the world's spare oil 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 supplying an additional barrel of oil to market. OPEC spare capacity provides an indicator of the world oil market's ability to respond to real and potential disruptions in world oil supplies.
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.
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 time 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 challenging 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. In recent years, conflicts and political events in the Middle East, the Persian Gulf, Libya, and Venezuela have contributed to world oil supply disruptions and increases in oil prices.
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 product, such as heating oil, to consumers in a short amount of time. 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 supply chains adjust, 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—on the spot purchases of a single shipment for prompt 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.
The outlook for crude oil prices is uncertain
The large changes in world oil prices in the past decade demonstrate how all of these factors can influence oil prices, and they demonstrate the difficulty in making projections for oil prices. The U.S. Energy Information Administration projects crude oil prices in the
- Short-Term Energy Outlook. See Table 2. Energy Prices
- Annual Energy Outlook. See Table 12 Petroleum and Other Liquids Prices in the Reference case and in side cases
Last updated: February 20, 2020