Factors that Affect Oil Prices

In today’s petroleum-dependent economy, oil prices are not just one among a great many commodities, but a vital indicator of overall economic performance. Rising oil prices can in some cases pose as great a threat to many businesses as rising interest rates. Consequently, a basic understanding of the factors that affect oil prices is a vital skill for anybody interested in investing. Oil prices have fluctuated wildly in recent years, from $145 US in mid-2008, to $30 at the end of that year, to around the $80-$85 range in mid-to-late 2010.

“Oil prices” are, in fact, a semi-fictitious price based on a quantity of oil which will never actually be exchanged: a barrel, equivalent to 159 litres or 42 American gallons. It has, of course, been a very long time since oil actually changed hands in barrels, but this measure remains a useful one for investing purposes. People bidding on oil in the markets are typically purchasing futures contracts for substantial numbers of barrels, and it is these open trades which determine the oil prices on any given day. Obviously, as with any other commodity, the oil prices tend to rise on the markets when investors believe demand will increase or supply will fall, and the oil prices tend to fall in the markets when investors fear demand is falling (although this is rare) or a vast supply of new oil has been discovered. Rises and falls in oil prices are not necessarily correlated to the stock performance of individual companies in the petroleum industry, although all else being equal, oil companies on the whole will obviously tend to bring in more revenue when oil prices are high than when they are low.

Factors that affect oil prices on the supply side involve factors affecting investors’ expectations about near- and long-term future oil production. Currently, oil production is continuing to increase, although obviously this cannot happen forever and there are numerous voices (and have been for years) claiming that we are nearing a so-called point of “peak oil,” after which oil production will fall precipitously. A bottleneck in any particular part of the production process – such as the lack of new refinery capacity in the U.S. – can also cause end prices to rise, since getting new oil out of the Earth serves little purpose if it cannot be promptly processed into something profitable.

Oil prices are also influenced by the production quotas established by the Organization of Petroleum-Exporting Countries (OPEC), a pseudo-cartel made up of oil-rich developing countries in the Middle East, plus Algeria, Angola, Ecuador, Nigeria, and Venezuela. OPEC’s influence has fallen due to increased oil production in Canada, off Britain, and in the Gulf of Mexico. However, other factors can also affect oil. Any suggestion of instability – due to a temporary shutdown of Gulf of Mexico drilling operations, for instance, or due to war in key Middle Eastern oil-rich regions – tends to cause a spike in prices.

Oil prices are also affected by factors on the demand side – that is, rises and falls in consumer demand for oil. In general, demand for oil today is consistently high, since oil is needed not just for fuel but for plastics and numerous other purposes. Oil demand – particularly for various end products – does fluctuate over the course of the year, however. Heating oil is in higher demand in winter, for instance, while gasoline is in much higher demand in the summer.

Finally, just as oil prices can have a major impact on overall economic health, macroeconomic factors can also have an important influence on oil prices. The large fluctuations in oil prices between 2008 and 2010 are in considerable part a reflection of the huge hit to investor confidence suffered in the wake of the subprime crisis of 2007-2008.