Given the status of oil as a global commodity in high demand can come the risk that large price fluctuations could be significant for economic reasons. The main factors that affect the pricing of petroleum are:
- Demand and supply
- Production costs
- Market sentiment
Supply & Demand
The idea of a demand or supply is quite easy to grasp. The price is expected to rise when demand rises (or decreases). When demand declines (or supply rises), the price will fall. Does that sound easy? Not quite. As we know, oil prices are determined by the market for oil futures. The oil futures contract is a legally binding agreement that allows one to purchase oil per barrel at a price predetermined at a specific date in the near future. In a futures contract, buyer and seller are bound to complete their part of the deal according to the date.
Oil Market Participants
There are two kinds of traders in the futures market:
- Hedgers
- Speculators
A good illustration of a hedger might be an airline purchasing oil futures to safeguard against the possibility of rising prices. A typical person has no idea of the direction of the price but does not intend to purchase the product. Based on CME Chicago Mercantile Exchange (CME), The majority of futures transactions conducted by speculators in which the buyer of a futures contract acquires possession of the product is less than 3 percent.
Sentiment
Another important factor in the determination of oil prices is sentiment. The mere fact that you believe that the oil demand will grow significantly in the future could lead to a significant increase in the prices of oil at present if hedgers and speculators alike buy contracts for oil futures.
Of course, the reverse is also the case. The fact that oil demand will decline at an upcoming time could result in a massive price drop since oil futures contracts are traded (possibly sold short too) and, therefore, prices may be affected by nothing more than market sentiment.
When the Economics of Oil Prices Don't Add Up
The supply and demand theory stipulates that the higher the product's quantity, the less expensive it will be sold, everything else being equal. It's a synergistic dance. More of a product was made at all because it was more economically efficient to make it so. If anyone were to develop a method of stimulation that could increase the output of an oil field for just a tiny cost while demand remains steady, prices would drop.
In reality, there were times when production increased. Oil production across North America was at an all-time high in 2019, which saw fields such as North Dakota and Alberta as productive as ever. If the COVID19 epidemic struck in early 2020 and many people stopped traveling because of lockdowns or other restrictions, the oil demand would plummet dramatically. However, gas prices fell somewhat and then rebounded quickly.
This is where the theory goes into practice. Production was high; however, refinement and distribution weren't enough to keep up. In the last decade, the United States has only built one refinery each decade (construction has slowed to only a tiny amount since the late 1970s). The net effect is a loss in there are two fewer refineries in USA has two fewer refineries than in 2009. However, the remaining 135 refineries in the nation have the capacity of any other country by a substantial amount. We're not bathed in oil at a bargain price because these refineries are operating at 90% capacity. If you ask a refiner, they'll inform you that the surplus capacity exists to meet the future demand.
Commodity Price Cycle Affecting Oil Prices
From a historical perspective, a 29-year (plus or less than the equivalent of one to two years) cycle could possibly control the movement of prices for commodities worldwide. From the start of the rise of oil as a commodity in high demand during the first half of 1900, major highs in the index of commodities were seen in 1920 as well as in 1958 and 1980. Oil reached its peak with the index of commodities in both 1920 and the year 1980. (Note that there was no absolute peak in oil in 1958 since it had been shifting in a downward trend since 1948 and continued to do this until 1968.) It is crucial to remember that supply, demand, and sentiment are more important than cycles as they are guidelines that are not guidelines.
