Crude oil prices are determined by global supply and demand. Economic growth is the biggest factor that affects demand. Growing economies require energy, and the petroleum products made from crude oil and other hydrocarbon liquids account for about 34% of the energy consumed worldwide.
The Organization of the Petroleum Exporting Countries (OPEC) can have a significant influence on prices by setting production targets for its members. OPEC members produced about 42% of the world's crude oil in 2014. If OPEC members limit production, they can influence global crude oil supply and prices. OPEC countries have close to three-fourths of the estimated world crude oil reserves and most of the spare crude oil production capacity.
Causes of world crude oil prices and supply disruptions
Crude oil and petroleum product prices can be affected by events that may disrupt the supply of crude oil and petroleum products to market, including geopolitical and weather-related events. These events can lead to actual crude oil supply or demand disruptions and can create uncertainty about future supply or demand. This 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 equipment that uses petroleum products as the main source of energy are relatively fixed in the near term. It takes years to develop new supply sources or to vary production, and it is hard for consumers to switch to other fuels or to increase fuel efficiency in the near term when prices rise. Under such conditions, a large price change can be necessary 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 disrupted because of political events. Several major oil price shocks have occurred at the same time as supply disruptions triggered by political events, 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, disruptions to supply from political events have occurred in Nigeria, Venezuela, Iraq, Iran, and Libya.
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. In 2005, hurricanes in the Gulf of Mexico region shut down oil production operations and many refineries that process crude oil into petroleum products. As a result, petroleum product prices increased sharply as supplies to the market dropped. Severe cold weather can 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 can result in higher prices for the commodity.
In addition to the previous examples, other events such as refinery outages or pipeline problems can restrict the flow of crude oil and petroleum products to market. These types of events can also lead to a temporary supply disruption that could increase prices for these commodities.
The influence of all 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.
There are different types of oil market transactions and prices
Contract arrangements in the oil market cover most crude oil that changes hands. 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.
Crude oil is also traded in the futures markets. A futures contract is a standardized 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 ensure their ability to sell and receive 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 advance of the expected date of their purchase. 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.
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.
Seasonal changes in demand can influence the supply and demand balance for crude oil, and thus, its market price. For example, crude oil markets tend to be stronger in the fourth quarter of the year (the high-demand quarter on a global basis, when demand is boosted both by cold weather and by inventory building) and weaker in the late winter as global demand for crude oil falls with warmer weather. This is also the case with petroleum products. For example, gasoline prices tend to rise in the summer because of increased consumption in the United States, the world's largest crude oil consumer.
Source: U.S. Energy Information Administration, Annual Energy Outlook 2015, Figure 3 (April 2015)
The outlook for crude oil prices is uncertain
The large changes in world oil prices in the past eight years demonstrate how the factors discussed above can influence oil prices, and they demonstrate difficulty in making projections for oil prices. The U.S. Energy Information Administration considers the implications of a wide range of price scenarios in its outlook publications:
The low and high oil spot price paths from the Annual Energy Outlook 2015 (shown in the chart at right) are not intended to provide lower and upper bounds for future oil prices but rather to allow the analysis of possible future world oil market conditions that differ significantly from those assumed in the Reference case.