Oil Price Analysis: The Impact of Supply and Demand

Oil is the crown jewel of commodities used in a multitude of ways, from plastics to asphalt to fuel. The oil industry is an economic powerhouse, and changes in oil prices are closely watched by governments, corporations, investors, and traders.

Volatile oil prices can send shockwaves throughout the global economy. Changes in the production and consumption of oil also drive prices. However, oil is not a diamond or caviar—luxury items of limited utility that most can live without. Oil is abundant and in great demand, making its price primarily a function of market forces.

Many variables affect oil prices, including the basic economic theory of supply and demand. The law of supply and demand states that if supply increases, prices will go down. Conversely, if demand rises, so too should prices. As a result, the question we're left with: What affects the supply and demand of oil?

Key Takeaways

  • Crude oil is the crown jewel of commodities making the oil industry an economic powerhouse in which oil prices are monitored closely.
  • The United States, Saudi Arabia, and Russia are the top three oil producers globally, producing nearly 40 million barrels per day in total in 2020.
  • Oil reserves within oil-producing countries are categorized as proven, probable, and possible reserves.
  • Supply and demand based on global economic conditions and geopolitical tensions can significantly impact oil prices.
  • OPEC, which is a cartel of oil-producing countries, still has the ability to determine oil supply and prices but to a lesser degree than in years past.



Supply and Demand

The consumption of oil consists of various companies and hundreds of millions of people who collectively influence prices. Oil production can also influence oil prices, particularly in countries that produce the largest amount of crude oil.

As of 2020, the United States is the largest oil producer in the world, outpacing the country which most would think is the largest producer: Saudi Arabia. The U.S. surpassed Saudi Arabia as the world's largest oil producer in 2018. The reason was due to shale fracking in Texas and North Dakota. However, in 2019, Saudi Arabia's oil production was down for the year compared to normal levels due to attacks on its oil fields, which disrupted production.

In 2020, the U.S. produced approximately 18.6 million barrels of oil per day. Saudi Arabia produced approximately 10.8 million and Russia produced approximately 10.5 million barrels per day. No other country is producing even half as much oil as any of the top three. Canada is a very distant fourth at 5.2 million barrels per day.

Capacity and Reserves

It may appear counterintuitive that the nations that produce the most oil and the countries that are most commonly identified with an abundance of oil aren’t necessarily the same. There is an important distinction between oil production and oil reserves. Oil reserves are oil in the ground that hasn't been turned into supply.

Types of Reserves

Typically, oil reserves are categorized as proven reserves (90%+ chance that oil can be extracted), probable reserves (50%+ chance that oil can be extracted), and possible reserves (at least a 10% probability that the quantities actually recovered will equal or exceed the sum of estimated proved plus probable plus possible reserves). Determining the type of oil reserves countries have can help determine where future oil supplies will come from and the ability of future supply to meet demand.

Countries with Reserves

As of 2020, Venezuela is the leader in that category, with reserves estimated at 303.8 billion barrels. However, most of their oil is offshore or deep underground, making it hard to reach. It is also dense oil, which makes it harder to refine into usable products, such as gasoline. Saudi Arabia has the second-largest reserves, with 297.5 billion barrels.

As for the United States, its proven reserves are less impressive than its current capacity. The U.S. has 68.8 billion barrels in reserve as of 2020, far behind Canada (168.1 billion), Iran (157.8 billion), Iraq (145 billion), and Kuwait (101.5 billion). The remaining countries ahead of the U.S. include some cordial ones (the United Arab Emirates, 97.8 billion), some antagonistic ones (Russia, 107.8 billion) and some whose friendliness is tentative (Libya, 48.4 billion).

From Well to Fumes

So what does a barrel of oil represent, let alone 13 million of them? It’s hard for people outside of the industry to visualize the production numbers, so let’s attempt to make sense of them. Most crude oil in the United States is used to make petroleum. Petroleum is used for fueling vehicles, providing electricity, heating buildings, making plastics, and many other goods. Current statistics for 2020 indicate that the U.S. consumed 20.5 million barrels per day, much higher than their own production levels.

In 2020, the breakdown in the use of petroleum was: 66% transportation, 28% industrial, 3% residential, 2% commercial, and 1% electric power. Consumption of motor gasoline was 8.0 million barrels a day, 44% of petroleum consumption. Gasoline is clearly the leader in terms of petroleum use.

Pumping, Refining, and Distribution

Basic supply and demand theory states that the more of a product is produced, the more cheaply it should sell, all things being equal. It's a symbiotic dance. The reason more was produced in the first place is because it became more economically efficient (or no less economically efficient) to do so. For example, if a well stimulation technique was invented that could double an oil field's output for only a small incremental cost, with demand staying static, prices should fall.

Oil Extraction

Technological developments have also impacted production and the costs to extract oil from the ground. Oil production in North America has surged, with fields in North Dakota and Alberta as fruitful as ever. Also, new supply has resulted from advancements in shale fracking. Fracking refers to hydraulic fracturing, in which fractures in rock formations are created by injecting fluid into the cracks to force them to open. As a result, petroleum or natural gas can be extracted from these subterranean wells.

Refining and Distribution

Despite the increase in oil production, crude oil prices have remained volatile and oftentimes high. The problem with the basic supply and demand theory is that distribution and refinement haven't always kept up with production.

For example, the United States does not build refineries often. Five refineries were built between 2014-2019 to keep up with production, but before 2014, the last refinery was built in 1998. Construction had slowed down to a trickle after the 1970s. A total of only two refineries were built in the 80s and three in the 90s, and these weren't built for large capacity. There's actually a net loss: the United States has fewer refineries than it did in years prior.

As of January 2021, the U.S. has 129 refineries in operation. So even though there is a large supply of oil, the ability to refine it and get it to market is limited, affecting the actual supply that is available for consumption.

OPEC: Waning Influence

Then there’s the problem of cartels. The Organization of the Petroleum Exporting Countries (OPEC) was founded in the 1960s. Although the organization’s charter doesn’t state this explicitly, they fix prices. By restricting production, OPEC can force oil prices to rise and thereby enjoy greater profits than if its member countries had each sold on the world market at the going rate. Throughout the 1970s and much of the 1980s, this was a sound if immoral strategy for OPEC.

According to the U.S. Energy Information Administration (EIA), OPEC member countries often exceed their quotas, selling a few million extra barrels and knowing that enforcers can’t really stop them from doing so. With Canada, China, Russia, and the United States as non-members, OPEC is limited in its ability to stabilize prices and supply.

How Geopolitical Tensions Impact Oil Prices

The oil industry is a global game and what happens in the world impacts the price of oil, especially since a large proportion of the world's biggest oil producers are in unstable areas.

Regions Susceptible to Tensions

Geopolitical tensions are often associated with many of the oil-producing countries, particularly in the Middle East. Saudi Arabia, Iraq, Iran, Kuwait, and Libya all fall in this region. However, other countries have added to the uncertainty of oil supply, impacting prices. Russia has been a nefarious player in global politics and suffered sanctions for being so, and Venezuela has been in a political crisis.

Terrorist attacks, sanctions, and other regional matters influence how these countries supply oil, determining how oil prices move. If these countries cannot supply oil because they are impeded, and demand remains constant, oil prices will rise.

Russia and Ukraine Tensions

Geopolitical tensions that began in late 2021, and escalated in early 2022, led to a 35% surge in the price of West Texas Intermediate (WTI). In mid-December 2021, Russian officials warned that Ukraine should not be included in the North Atlantic Treaty Organization (NATO) and that NATO forces should be withdrawn from Eastern Europe. The U.S. and Nato refused, and these tensions would roil energy markets.

In early 2022, Russia began military operations in Ukraine, which centered around the separatist regions in the east and other targets within the country. As a result, WTI oil prices spiked from $74.32 on Dec. 15, 2021, to $100, while Brent crude shot up to more than $105 during intraday trading in early 2022.

The economic sanctions that resulted from geopolitical tensions can also lead to volatility in the energy markets. On Feb. 22, 2022, U.S. President Joe Biden announced sanctions that included blocking two state-owned Russian financial banks and their subsidiaries, which provide financing to the Russian military. Sanctions also banned Russian sovereign debt purchases within the U.S. and targeted Russian elites and their families.

However, on Feb. 24, 2022, sanctions were expanded in scope to include other Russian financial institutions, including the two largest banks—Sberbank and VTB Bank—blocking access to the U.S. financial system. Sanctions also prohibit U.S. individuals from buying both new and existing Russian sovereign debt in the secondary market. Russian elites and their families have been financially targeted, while export controls were put in place to block the importing of technological goods into Russia.

The Bottom Line

The oil industry is complex, with many different components and players. Natural laws of supply and demand come into play, as with any free market. Still, each is impacted by the components of the oil industry, such as refining capability, oil reserves, and foreign affairs.

Article Sources
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