Understanding Oil Markets


The oil market is affected by many economic and political factors, many of which have been in the news recently because of the focus on increased prices at the gas pumps. The basic laws of supply and demand have a strong fundamental impact on the price of crude oil, which eventually dictates the price of other, refined oils. But, in addition, the perception of increased or decreased demand and supply also has a major impact on prices.

“The upward pressures on prices in such a tight market situation – with the expected prolonged downstream bottlenecks – in particular, prices of light products and related benchmark crudes, like West Texas Intermediate; concern about future supply, again fed and amplified by worries about future product shortages; (leading to) greater speculative activity in futures markets, and hence upward cycles of increased prices and volatility.” (Comments by Dr Adnan Shihab-Eldin, Acting for the OPEC Secretary General, at the OPEC/IEA luncheon, at the 18th World Petroleum Congress, in Johannesburg, South Africa, on 28 September 2005).

Logically, in the physical oil market, sometimes people want more oil than producers can produce and at those times, the price should go up. Other times, when producers can sell more than people are willing to buy, the price should drop. However, oil, like other commodities, is bought and sold on commodities markets by speculators, investors, and traders as well as by companies who make or use oil. The jitteriness reflected in Dr. Shihab-Eldin’s remarks very realistically portrays the psychological impact of oil traders’ perception of future prices. If traders believe prices will go up, they will behave in the commodities markets in such a way as to force prices up, even when there is ample supply.

Increased economic strength in developing countries such as India and China will increase demand and induce traders to continue to buy oil futures, forcing prices up.

Another factor that affects market perception and therefore price is political instability in the Middle East, the largest producer of crude oil. If a steady supply of crude oil becomes threatened, there is additional reason for traders and speculators to buy oil and further force prices upward.

OPEC, the Organization of Petroleum Exporting Countries, also has a vested interest in limiting, or at least giving the appearance of limiting supply so as to prop up prices. The production of oil is very lucrative and almost their only source of income. For this reason, OPEC controls the flow of oil to the rest of the world. Both OPEC and non-OPEC producers want to continue to produce as much oil as possible in order to maximize income, but they have to be careful not to create an image of an unending supply of oil, which would force prices down.

Of course, oil is a finite resource, so when supplies do diminish, prices will escalate beyond the consumer’s current threshold of acceptance. A corollary to the law of supply and demand is that the escalating price caused by limited supply will eventually lead to substitution. But in the current environment, oil producers can control prices by keeping enough pressure on supply to support high prices, but release supplies to discourage substitution.

 

Information is for educational  purposes only and is not be interpreted as financial advice. This does not represent a recommendation to buy, sell, or hold any security. Consult your financial advisor.

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