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What Determines Oil Prices?

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What Determines Oil Prices?

In 2022 the world is facing a rise in oil prices. Why are oil prices rising so rapidly? What are the global impacts of high oil prices? Read on this explanation to understand more about oil prices.

The factors that affect oil prices

Before we look at the main determinants of oil prices, we must remember that oil is used in almost everything in the global economy. Even despite the global economy's movement towards a greener world, oil still holds a very important role.

The main factors that determine oil prices are:

  1. Supply and Demand.
  2. Market sentiment (investors and futures contracts).
  3. Politics.
  4. Natural disasters.

We will take a look at each factor in more detail now.

Demand and supply of oil

Under perfect circumstances, the rules of demand and supply are simple: as the price of a good or service increases, the demand for said good or service decreases. The opposite also holds true: a decrease in the price of a good or service will lead to an increase in demand.

But that is not necessarily the case with oil. As we mentioned earlier, oil is used in almost everything. This means that there will always be demand for oil, even if oil prices are high or if there is a limited supply of it.

Oil supply

Supply determines how much oil is available in the market. The supply of oil is usually determined by the member states of the OPEC.

The Organization of Petroleum Exporting Countries (OPEC) is made up of 13 of the world's main oil-exporting countries. Figure 2 contains the 13 countries.

What Determines Oil Prices? Graph of the OPEC Countries that offer the oil supply StudySmarterFigure 2. OPEC countries, Alanna Odagbu - StudySmarter.Created with icons from Flaticon.

OPEC controls 40% of the world's supply of oil. Thus, if an OPEC nation decided to pump out more crude oil out of their natural sources, the overall supply of oil would increase.1

In 2014, Saudi Arabia, one of the largest producers of oil, decided not to reduce its oil production. This caused other major oil producers such as the United States, as well as other nations in the OPEC (The Gulf states for example), to increase their output to remain competitive in the market.2 As a result, oil prices decreased sharply as oil producers around the world produced more oil than the world would be able to consume.

As you can see, geopolitics affect the oil supply. Another example, are regional conflicts. These can push oil-producing nations to place embargos on each other. This leads to sharp rises in oil prices and a shortage of oil in the market.

In 1973, during the Arab-Israeli war, Arab members of OPEC placed an embargo on the US which seriously impacted the US economy.

You can learn more about this embargo and its impacts on the US economy with our Oil Crisis 1973 explanation.

Oil demand

Demand is essentially based on how much oil a country, market, or economy needs at a certain point in time.

Let’s say that a country is experiencing economic growth. There is an increase in transactions for goods and services, transportation in the forms of cars, planes or other mediums, and there are new building production facilities all around the country. In this case, that country would probably see an exponential increase in oil demand.

Of course, this could change over time. The new trends seem to be going towards renewable energies. However, right now these changes appear costlier than the use of oil.

Market sentiment and oil prices

Market sentiment is the overall attitude of investors towards a particular security, commodity, stock, etc., or the financial market as a whole.

We have already established the notion that demand and supply as well geopolitics are strong influencing factors in oil prices. However, the specific price of oil as a commodity is determined in the futures market of oil.

Futures are financial contracts that obligate the buyer to buy the asset and the seller to sell the specific asset at a predetermined time and future date.

In the oil industry, the oil future contract obliges the buyer to purchase a specific amount of barrels of oil and the seller is obliged to sell that specific amount of barrels of oil at a specific date and time.

The majority of trading that occurs in the future oil market is done by speculators.

Speculators are investors that use investment strategies based on short-term utility.

The main goal of speculators, unlike long-term investors who use passive investment methods, is to outperform such investors by trading and speculating about the future price direction a specific commodity takes.

If the possibility of an increase in oil demand arises, we would see an increase in oil prices. This would lead to future oil contracts being purchased as the value increased. The opposite, however, is also true: if the markets have the sentiment that oil prices were to decrease, the prices would also decrease. This would lead to the scenario of future contracts of oil being sold in the market.

Politics and oil prices

We have already considered how politics regarding OPEC countries can influence oil prices. But global political instabilities even in nation-states independent of OPEC that are also major oil-producing nations can influence oil prices.

Russia is not an OPEC country, yet it supplies Europe and other large economies, such as Japan and China. With the current (2022) Ukraine - Russia crisis, oil is expected to reach $300 per barrel if Western countries impose an embargo or other bans on Russian energy suppliers. 3

Figure 3 below shows the main countries reliant on Russian gas exports.

What Determines Oil Prices Russias gas exports StudySmarter Originals

Figure 3. Russia's gas exports, StudySmarter Originals.
Source: www.iea.org.

As we can see, Germany is extremely reliant on Russian oil. The German economy would be especially vulnerable if a ban or embargo was imposed.

Natural disasters and oil prices

Although mainly a case in the US, a natural disaster such as an earthquake, volcanic eruption, or hurricane can lead oil prices to rise sharply.

In 2005, Hurricane Katrina hit the south of the US. This hurricane affected almost 20% of the US oil supply and it caused the price per barrel to rise by $13.4

The impact of Covid-19 on oil prices

The transportation sector is heavily dependent on crude oil for its ongoing activities and services. This includes cars, aeroplanes, and ships. All of these transportation mediums require petroleum to continue their operation processes.

Covid-19 has singlehandedly polarised the transportation and logistics industry from shutting down trade operations between nations to causing an increase in the crackdown of travel restrictions to clamp down on the spread of the virus.

The oil industry, much like the tourism and gastronomy industry, was hit hard by the pandemic: the industry suffered a demand shock. Oil reserves that should have been utilised for operating processes such as transportation were left untouched and this led to an oversupply of oil. In other words, there were too many reserves of oil. This led to a significant drop in demand for oil and a subsequent drop in oil prices globally.

Saudi Arabia, one of the leading oil-producing nations and a member of OPEC urged member states of the organization to cut back their production to maintain steady price levels. Russia refused after failed negotiations. This eventually led to a price war between these two nations which further exacerbated the fall in prices.

The price war eventually ended and the nation-states of OPEC and their allies (EU, US, China, etc.) agreed to cut back on oil production by 9.7 million barrels of oil, one of the largest cutbacks in history.5

The failure to anticipate the impact of the pandemic and the slow response, coupled with the disagreements with Russia over the production levels that led to a price war only served to increase the price volatility of the oil market and drastically deteriorated the situation overall. Despite the measures taken, oil prices reached their lowest minimum in 2020.

The impact of falling oil prices on the global economy

A fall in oil prices can lead to a reduction in transportation, logistics, and fuel costs for the firms in an economy. General consumers, such as normal households, can benefit from lower oil prices as they will have more income available to spend on goods and services. An increase in consumption could spur an increase in aggregate demand.

A fall in oil prices can occur due to a fear of a recession or other unexpected factors like Covid-19. This negative sentiment can build up and lead to a fall in oil prices, which could lead to reduced economic growth.

If the drop in oil prices remains consistent and it keeps happening over a period of time, there is a possibility of oil firms having too much debt and liquidating because of the risings costs.

With the pandemic, for example, many oil firms have suffered losses on their balance sheet and have gone out of business. Many workers for example had to be laid off to cover for the debt. This resulted in greater unemployment levels as well as lower investments.

Perspective also plays an important role in this. Exporting nations like Saudi Arabia or Russia will suffer from falling price levels as they won't be able to make sufficient revenues for their budget. Conversely, oil-importing nations like Germany, the UK, or Spain will benefit from a drop in oil prices.

Other industries that also rely on oil to produce other forms of goods and services can also suffer.

What determines oil prices? - Key takeaways

  • Prices of oil are determined by the natural laws of demand and supply as well as other external factors such as politics, market sentiments, and natural disasters.
  • OPEC plays a large role in influencing the supply of oil and influencing the price a barrel of oil can be sold in the market
  • Political instability and natural disasters both can have a major impact on why oil prices may fluctuate as these events come in unexpected times and can cause demand shocks.
  • COVID 19 has deterred the oil market like never before and we have seen oil prices drop to its lowest in 20 years.
  • The transportation and logistics sector is heavily dependent on the oil industry be it the car manufacturers or the airlines, both industries require petroleum to function.
  • Falling prices for oil exporting countries can result in higher levels of debt, balance of payment issues as well as an economic recession.
  • The commodity of oil is traded in the futures market where the buyer is obliged to purchase the commodity and the seller is obliged to sell the commodity at a pre-determined price and time.

Sources

1. U.S. Energy Information Association, ‘What drives crude oil prices?’, 2022, https://www.eia.gov/finance/markets/crudeoil/supply-opec.php

2. Jaden Urbi, ‘Here’s what drives the price of oil’, CNBC, 2018.

3. Reuters, ‘Russia warns West of $300 per barrel oil, cuts to EU gas supply’, 2022,

4. U.S. Energy Information Association, ‘Petroleum & other liquids’, 2022, https://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=F000000__3&f=A

5. Michael Lynch, ‘The Impact of COVID-19 on Oil Prices’, GLG, 2020.

Frequently Asked Questions about What Determines Oil Prices?

The main factors that determine oil prices are:

  1. Supply and demand
  2. Market sentiment (investors and futures contracts)
  3. Politics
  4. Natural disasters

Oil prices dropped during Covid-19 because of the excess reserves of barrels of oil that remained untouched due to low demand for oil. Additionally, the price war between Saudi Arabia and Russia exacerbated the fall in oil prices.

Oil prices fluctuate because of the constant changes to supply and demand.

A fall in oil prices benefit consumers as they spend less on energy, fuel, etc. and this allows them to have more disposable income left over to spend on other goods and services. 


The increase in consumption can increase aggregate demand. However, for oil-dependent countries that make revenue from oil, it is not good as they receive less revenue from oil exports.

The market forces that impact oil prices are supply and demand.

Final What Determines Oil Prices? Quiz

Question

Oil holds an important part in the global economy.

Show answer

Answer

True

Show question

Question

What are the main factors that determine the prices of oil?

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Answer

The main factors that determine oil prices are:

  1. Supply and demand
  2. Market sentiment (investors and futures contracts)
  3. Politics
  4. Natural disasters

Show question

Question

As the price of a good or service increases, the demand for that said good or service ______.

Show answer

Answer

decreases

Show question

Question

A decrease in the price of a good or service will lead to an ______ in demand.

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Answer

increase

Show question

Question

What is OPEC?

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Answer

The Organization of Petroleum Exporting Countries (OPEC). The 13 world’s main oil-exporting countries.

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Question

Name 5 countries that are part of OPEC.

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Answer

Any 5 from:

  1. Algeria
  2. Angola
  3. Equatorial Guinea
  4. Gabon
  5. Iran
  6. Iraq
  7. Kuwait
  8. Libya
  9. Nigeria
  10. the Republic of the Congo
  11. Saudi Arabia
  12. the United Arab Emirates
  13. Venezuela

Show question

Question

What percent of the world's supply of oil does OPEC control?

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Answer

40%

Show question

Question

Define futures.

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Answer

Futures are financial contracts that obligate the buyer to buy the asset and the seller to sell the specific asset at a predetermined time and future date.

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Question

What are speculators?

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Answer

Speculators are investors that use investment strategies that are based on short-term utility.

Show question

Question

What does market sentiment refer to?

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Answer

Market sentiment is the overall attitude of investors towards a particular security, commodity, stock, etc. or the financial market as a whole.

Show question

Question

Which European country is largely dependent on Russian oil?

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Answer

Germany

Show question

Question

Give an example of how a natural disaster can influence the price of oil.

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Answer

In 2005, Hurricane Katrina hit the south of the US. This hurricane affected almost 20% of the US oil supply and it caused the price of per barrel to rise by $13.

Show question

Question

Oil prices during Covid-19... 

Show answer

Answer

fell

Show question

Question

Explain how Covid-19 led to a fall in oil prices.

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Answer

Many oil reserves were left untouched and this lead to an oversupply of oil. There were too many reserves of barrels of oil and this lead to a significant drop in demand for oil and a subsequent drop in oil prices globally. 


Additionally the price war between Saudi Arabia and Russia further exacerbated the fall in prices. 

Show question

Question

How does a fall in oil prices impact the global economy?

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Answer

A fall in oil prices lead to a reduction in transportation, logistics and fuel costs for the firms within an economy. Consumers also benefit from lower oil prices as they will have more income available to spend on goods and services. An increase in consumption could spur on an increase in aggregate demand. For oil importing countries, they benefit from lower priced oil imports.


But for oil dependent countries, the falling prices of oil make it difficult for them to generate sufficient revenue for their budget. 

Show question

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