Oil is a commodity, and as such, it tends to see larger fluctuations in price than more stable investments such as stocks and bonds. There are several influences on oil prices, a few of which we will outline below.
- Oil prices are influenced by a variety of factors but are particularly responsive to decisions about output made by OPEC, the Organization of Petroleum Exporting Countries.
- Like any product, the laws of supply and demand influence prices; a combination of stable demand and oversupply has put pressure on oil prices over the last five years.
- Natural disasters that could potentially disrupt production, and political unrest in an oil-producing juggernaut like the Middle East all impact pricing.
- Production costs influence prices, along with storage capacity; although less impactful, the direction of interest rates can also influence the price of commodities.
OPEC Influences Prices
OPEC, or the Organization of Petroleum Exporting Countries, is the main influencer of fluctuations in oil prices. OPEC is a consortium made up of 14 countries: Algeria, Angola, Ecuador, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. OPEC controls 40% of the world's supply of oil. The consortium sets production levels to meet global demand and can influence the price of oil and gas by increasing or decreasing production.
OPEC vowed to keep the price of oil above $100 a barrel for the foreseeable future, but in mid-2014, the price of oil began to tumble. It fell from a peak of above $100 a barrel to below $50 a barrel. OPEC was the major cause of cheap oil, as it refused to cut oil production, leading to the tumble in prices.
Supply and Demand Impact
As with any commodity, stock or bond, the laws of supply and demand cause oil prices to change. When supply exceeds demand, prices fall and the inverse is also true when demand outpaces supply. The 2014 fall in oil prices can be attributed to a lower demand for oil in Europe and China, coupled with a steady supply of oil from OPEC. The excess supply of oil caused oil prices to fall sharply. Oil prices have fluctuated since that time, and are valued at approximately $54 per barrel as of September 2019.
While supply and demand impact oil prices, it is actually oil futures that set the price of oil. A futures contract for oil is a binding agreement that gives a buyer the right to buy a barrel of oil at a set price in the future. As spelled out in the contract, the buyer and seller of the oil are required to complete the transaction on the specific date.
Natural Disasters and Politics Weigh
Natural disasters are another factor that can cause oil prices to fluctuate. For example, when Hurricane Katrina struck the southern U.S. in 2005, affecting 19% of the U.S. oil supply, it caused the price per barrel of oil to rise by $3. In May 2011, the flooding of the Mississippi River also led to oil price fluctuation.
From a global perspective, political instability in the Middle East causes oil prices to fluctuate, as the region accounts for the lion’s share of the worldwide oil supply. For example, in July 2008 the price of a barrel of oil reached $136 due to the unrest and consumer fear about the wars in both Afghanistan and Iraq.
The United States consumes almost one-fourth of the world's oil.
Production Costs, Storage Have Impact
Production costs can cause oil prices to rise or fall as well. While oil in the Middle East is relatively cheap to extract, oil in Canada in Alberta’s oil sands is more costly. Once the supply of cheap oil is exhausted, the price could conceivably rise if the only remaining oil is in the tar sands.
U.S. production also directly affects the price of oil. With so much oversupply in the industry, a decline in production decreases overall supply and increases prices. The U.S. has an average daily production level of 9 million barrels of oil, and that average production, while volatile, has been trending downward. Consistent weekly drops put upward pressure on oil prices as a result.
There are also ongoing concerns that oil storage is running low, which impacts the level of investments moving into the oil industry. Oil diverted into storage has grown exponentially, and key hubs have seen their storage tanks filling up rather quickly. More than 77% of storage capacity is being used in Cushing, Okla., one of these hubs. However, slowing production and pipeline network improvements will reduce the chance that oil storage will reach its limits, which helps investors shed their fears of too much supply and a rise in oil prices.
OPEC is widely seen as the most influential player in oil price fluctuations, but basic supply and demand factors, production costs, political turmoil, and even interest rates can play a significant role in the price of oil.
Interest Rate Impact
While views are mixed, the reality is that oil prices and interest rates have some correlation between their movements, but are not correlated exclusively. In truth, many factors affect the direction of both interest rates and oil prices. Sometimes those factors are related, sometimes they affect each other, and sometimes there's no rhyme or reason to what happens.
One of the basic theories stipulates that increasing interest rates raise consumers' and manufacturers' costs, which reduces the amount of time and money people spend driving. Fewer people on the road translates to less demand for oil, which can cause oil prices to drop. In this instance, we'd call this an inverse correlation.
By this same theory, when interest rates drop, consumers and companies are able to borrow and spend money more freely, which drives up demand for oil. The greater the usage of oil, which has OPEC-imposed limits on production amounts, the more consumers bid up the price.
Another economic theory proposes that rising or high-interest rates help strengthen the dollar against other countries' currencies. When the dollar is strong, American oil companies can buy more oil with every U.S. dollar spent, ultimately passing the savings on to consumers. Likewise, when the value of the dollar is low against foreign currencies, the relative strength of U.S. dollars means buying less oil than before. This, of course, can contribute to oil becoming costlier to the U.S., which consumes almost 25% of the world's oil.