Crude Oil Price; What Drives It?

The oil price has fallen by more than 45% since June, when it was $115 a barrel. It is now below $64. This comes after nearly five years of stability. At a meeting in Vienna on November 27th the Organisation of Petroleum Exporting Countries (OPEC), which controls nearly 40% of the world market, failed to reach agreement on production curbs, sending the price tumbling. Also hard hit are oil-exporting countries such as Russia (where the Ruble has hit record lows), Nigeria, Iran and Venezuela. What exactly affects oil prices and why is the price falling?

Crude Oil Prices

What exactly affects oil prices?

The oil price is determined mainly by several factors that can be classified into:

  • Current and Expected Supply
  • Current and Expected Demand
  • Inventories or Physical Balancing
  • Markets and Market Behavior

Supply:

Crude oil supply regimes can be classified into OPEC and Non-OPEC supply. OPEC supply account for about 40% of the global output and about 60% of traded oil. OPEC output is regulated by the producing countries. Production quotas/targets are assigned to member countries to keep the total output at a desired level. OPEC oil supply goes a long way to determining the price of crude as oil prices have been observed to rise anytime OPEC reduces its output.

Non-OPEC suppliers are mainly driven by IOCs who seek primarily to increase shareholder value and make investment decisions based on economic factors. Producers in non-OPEC countries are generally regarded as price takers, that is, they respond to market prices rather than attempt to influence prices by managing production (EIA). Anticipation/speculation of a change in supply can also affect the oil price. Supply can be disrupted by geopolitical unrest and natural disasters.


Demand:

Energy demand is propelled by increased economic activities. Oil consumption goes into heating of homes/offices (winter period) and cooling of homes/offices (hot countries and summer periods), transportation etc.

The Organization of Economic Cooperation and Development (OECD) consists of the United States, much of Europe, and other advanced countries. At 53 percent of world oil consumption in 2010, these large economies consume more oil than the non-OECD countries, but have much lower oil consumption growth. Oil consumption in the OECD countries actually declined in the decade between 2000 and 2010, whereas non-OECD consumption rose 40 percent during the same period. China, India, and Saudi Arabia had the largest growth in oil consumption among the countries in the non-OECD during this period (EIA). The OECD drives for improved energy efficiency and improvement on the energy mix to support consumption of cleaner energy. The more the energy demand, the more likely it is to see an increase in the price of oil.


Inventories:

Countries that are heavy consumers of Oil store some quantities for certain reasons. Inventories act as the balancing point between supply and demand. During periods when production exceeds consumption, crude oil and petroleum products can be stored for expected future use. In the economic downturn of late 2008 and early 2009, for example, the unexpected drop in world demand led to record crude oil inventories in the United States and other OECD countries. In contrast, when consumption outstrips current production, supplies can be supplemented by draws on inventories to satisfy the needs of consumers (EIA). Given the uncertainty of supply and demand, petroleum inventories are often seen as a precautionary measure. Since some consumers have stored crude, they can decide to buy or use from inventory hence affecting the oil price.

 

Markets and Market behavior:

Oil is a commodity and involves buying and selling by marketers who want to make certain profits. Market participants not only buy and sell physical quantities of oil, but also trade contracts for the future delivery of oil and other energy derivatives. One of the roles of futures markets is price discovery, and as such, these markets play a role in influencing oil prices.

Oil market trading activity involves a range of participants with varying motivations, even within individual participants. Some, such as oil producers and airlines, have a significant commercial exposure to changes in the price of oil and petroleum-based fuels, and may seek to hedge their risk by buying and selling energy derivatives. For example, an airline may want to buy futures or options in order to avoid the possibility that its future fuel costs will rise above a certain level, while an oil producer may want to sell futures in order to lock in a price for its future output.

These market drivers in addition to the comparative cost of oil (compared to other commodities) drive the price of oil in a particular direction.

 

Why is the price falling?

The major reason why the price oil oil seems to be nose-diving in the past weeks can be traced to the following:

  • There has not been any significant increase in demand for oil. While there has been increase in energy demand, there has been notable switch towards the consumption of cleaner energies in the energy mix. Natural gas notably has seen greater application in several economies.
  • The crisis in several producing countries like Libya, Iraq and Nigeria has not affected their output making the market resilient to geopolitical risks.
  • United States of America (the largest consumer of oil) have become the largest producer of oil via its new exploration methods on unconventional reservoirs. Though USA does not export its crude, it now imports less, cutting off its imports from several countries.
  • OPEC’s decision not to curb production is one major reason why the oil price is going down. Saudi and the Gulf allies can withstand even lower prices and would not reduce production to improve the price.

 

What does the Future Hold?

The future is not very bright either. Some oil and gas majors have borrowed money to engage in projects that will yield oil at relatively high production cost per barrel. Some countries depend heavily on oil exports and would not support any reduction of output for the sake of their economies.

We should expect a cut back in oil and gas explorations especially the non-conventionals and the deep offshore projects. Producing companies will drive to produce more but cheaper oil. The recovery will depend greatly on how two countries decide to react:

  • How the USA reacts to its energy demand and its oil import regulations
  • How Saudi Arabia decides to react with its production quota.

 

See the Short Term Forecast Here

Written by Chima Agbo (an Oil & Gas West Africa contributor)

Credit: EIA and The Economist


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