As a commodity, oil tends to see higher price volatility than more stable investments such as stocks and bonds. Several impacts on oil prices will be described in the next section.
OPEC Impacts Prices
OPEC, or the Organization of Petroleum Exporting Countries, is the primary factor in oil price variations. Algeria, Angola, Congo, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Saudi Arabia, the United Arab Emirates, and Venezuela constitute OPEC as of 2021.
According to statistics from 2018, OPEC controls about 80 percent of the world’s oil reserves. The consortium determines production levels to satisfy global demand and can affect oil and gas prices by raising or decreasing output.
Prior to 2014, OPEC pledged to keep the price of oil over $100 per barrel for the foreseeable future. However, by mid-2014, the price of oil had begun to decline. It dropped from above $100 per barrel to below $50 per barrel. 3 OPEC was the primary reason of cheap oil in that instance, as it refused to reduce oil output, resulting in a price decline.
Demand and Supply Impact
As with any commodity, stock, or bond, oil prices fluctuate due to the principles of supply and demand. When supply exceeds demand, prices decline, and vice versa when demand exceeds supply.
The substantial decline in oil prices in 2014 has been linked to a combination of decreased oil demand in Europe and China and a stable supply of oil from OPEC. The abundant supply of oil precipitated a significant decline in oil prices.
Although supply and demand effect oil prices, oil futures truly determine the price of oil. A futures contract for oil is a legally binding contract that grants the buyer the right to purchase a barrel of oil at a certain price in the future. The contract stipulates that the buyer and seller of the oil must complete the transaction by a certain date.
Natural Disasters
Natural disasters are another variable that might affect oil prices. In 2005, when Hurricane Katrina devastated the southern United States, disrupting about 20 percent of the nation’s oil supply, the price per barrel of oil increased by $13.56. In May 2011, the flooding of the Mississippi River also caused fluctuations in oil prices.
Political Uncertainty
Political instability in the Middle East affects fluctuations in oil prices from a global perspective, as the region supplies the majority of the world’s oil. In July 2008, for instance, the price of a barrel of oil hit $128 due to unrest and consumer apprehension regarding the conflicts in Afghanistan and Iraq.
Production Expenses and Inventory
In addition to production expenses, oil prices can grow or fall based on supply and demand. While oil extraction in the Middle East is relatively inexpensive, oil extraction in Alberta’s oil sands is more expensive. 10 If the only remaining oil is in tar sands, the price may climb once the supply of inexpensive oil is depleted.
Oil prices are also directly affected by U.S. output. Given the industry’s extreme oversupply, a fall in production reduces total supply and raises prices.
In February of 2020, the United States produced around 12.7 million barrels of oil per day on average. This average production can decline, notwithstanding its volatility. Consistent weekly declines exert upward pressure on oil prices.
The amount of oil diverted into storage has increased rapidly, and storage tanks at important hubs are swiftly filling up. Cushing’s storage hub stores around 60 million barrels as of mid-April 2020, with a total capacity of 76 million barrels.
Interest Rate Impact
There is a link between the changes of oil prices and interest rates, despite differing opinions. However, their correlation is not strong. In reality, a variety of factors influence both the direction of interest rates and oil prices. Sometimes these factors are related, sometimes they influence one another, and sometimes there is no discernible pattern or explanation for what occurs.
One of the fundamental hypotheses posits that rising interest rates increase consumers’ and manufacturers’ costs, hence reducing the time and money individuals spend driving. Less people on the road means less demand for oil, which can lead to a decline in oil prices. In this case, we would refer to this as an inverse correlation.
According to the same principle, when interest rates fall, people and businesses are able to borrow and spend more freely, hence increasing the demand for oil. With increasing oil use, consumers bid up the price.
Another economic theory suggests that rising or high interest rates strengthen the dollar relative to foreign currencies. When the dollar is strong, American oil corporations are able to purchase more oil for each dollar of U.S. currency spent, ultimately passing on the savings to consumers.
Similarly, when the dollar’s value is low relative to foreign currencies, the relative strength of U.S. dollars permits the purchase of less oil than before. Considering that the United States consumes 20 percent of the world’s oil, this can lead to oil being more expensive.
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