What factors drive the oil price?

The oil price was, for decades, largely dictated by demand from the US and supply from the OPEC group of oil producers, but the rapid rise of US shale oil output and incredible economic growth in China mean that the global oil price now has many more driving factors. Here’s what they are.

Oil pipeline
Source: Bloomberg

Global supply and demand

The turn of the century marked the start of a dramatic shift in the world oil market. No more was price dictated by demand from the US, the world’s largest oil consumer, and supply from the 14 members of the Organisation of the Petroleum Exporting Countries (OPEC). China has rapidly emerged as the world’s second-largest oil consumer, with India leap-frogging Japan to move into third. This has coincided with technological developments that have allowed oil to be extracted from shale rock, meaning US oil production has soared.

This new landscape in the global oil supply-and-demand balance has been evident in the huge fluctuations in prices over the past 16 years. Back in 2000, the oil price was trading at about $38 a barrel, but rose almost unchecked for the next eight years as the Chinese economy boomed, reaching a peak of over $150 a barrel in June 2008. Global demand then outstripped supply, particularly as the second Iraq War (2003 – 2006) took a key producer out of the market. The shock of the global financial crisis in 2008 briefly sent the oil price plunging back to about $50 a barrel, but it quickly recovered as China’s insatiable demand continued, and hit a new peak of nearly $120 in 2011. 

Then, in mid-2014, the price tumbled again. This coincided with growing fears about a slowdown in the Chinese economy, plus the boom in US shale oil production that had seen US net imports of crude oil and petroleum products fall from a peak of over 13 million barrels a day in 2006 to below five million barrels a day. Even as prices slid, dropping below $30 a barrel in January 2016 for the first time since 2002, OPEC, led by the world’s largest oil producer Saudi Arabia, kept pumping at record levels. Their stated aim was to protect market share, but in fact they were taking share back from the US shale oil industry, which had a far higher cost of production. Many of those US drillers stopped pumping – however although technology is still moving forward, and the cost of shale oil production falling, so US rig counts have started to rise once more.

Supply and demand is predicted to rebalance in 2017, but it’ll take a while longer for the global supply glut to be reduced and stock levels to return to historical norms.

Geopolitics and supply shocks 

The supply side of the oil market is particularly prone to geopolitical influences and resulting supply shocks. Many of the world’s biggest producers are in the Middle East, and so supply has been affected by things like the Iraq wars, sanctions on Iran, and the Arab Spring in Libya. Russia, currently under sanctions because of its annexation of Crimea, is one of the major sources of supply outside of OPEC.

There is also the impact of terrorism to consider. Major African producer Nigeria has struggled to keep output levels steady due to terror groups striking at its oil facilities and pipelines. Although the impact is often short-lived for individual incidents, the cumulative impact can have a noticeable effect on supply levels.

How does an investor track the global supply and demand picture? 

As described, the supply and demand equation has many key drivers. However, it is possible for investors to track the situation, and there are key figures that tend to drive the price. Here are some of them:

Global economic data: Particularly those which give signals on the health of the Chinese economy. China doesn’t provide reliable oil demand statistics, so the broader economic data needs to be used as an indicator of underlying demand.

US oil data: These include weekly oil and oil products inventory data from the US Energy Information Administration and weekly rig count data compiled by Baker Hughes. 

OPEC: The organisation produces a monthly oil market report which sets out the state of play in world oil markets and gives the latest production figures from its members. More important are its meetings, where oil ministers from the 14 members of the group meet to discuss things like production ceilings and supply freezes. Meetings among a group that includes Middle East political rivals like Saudi Arabia, Iran and Iraq do not always end in agreement.

The US dollar

A major factor in determining the direction of oil prices is the direction of the US dollar. Oil is priced in dollars. So when the dollar rises in value, oil falls in value relative to it. For this reason, there tends to be an inverse relationship between the dollar and the oil price – when the dollar rises, the price of oil falls and vice versa.

The weather

The weather across the globe often impacts the oil prices, although the impact tends thankfully to be short-lived. The wildfires in Canada that hit some of the country’s oil sands areas caused prices to rise for a short time – prices promptly fell again when the fires were doused.

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