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Ten Factors that Affect the Price of Oil

The price of gas affects a variety of goods and services because many economic activities use oil as an energy source.  No one likes to pay higher prices, but the global oil market is more complicated than most people realize, and the price of oil is dependent upon many different factors.Figure 1 shows a spike in oil prices post Hurricane Katrina in 2005.  Then, it shows the gas spikes in 2006 and 2007 that followed legislation removing the chemical MTBE from gasoline, and during the global recession, as the demand for oil decreased, so did prices. These items – natural disasters, legislation, and the economy – are just a few examples.  Here’s a deeper look into the top ten factors that affects the price of oil.

#1:  OPEC (The Organization of Petroleum Exporting Countries)

OPEC, a consortium of 13 countries: Algeria, Angola, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela, is the single largest entity impacting the world’s oil supplies . OPEC is responsible for 40% of the world’s oil production, and sets policies among member countries to meet global consumption. OPEC can affect the price of crude oil, by increasing or reducing production among member countries. The 2007 and 2008 increase in oil prices was due to reductions in OPEC production allocations in 2006.

#2:  Supply and Demand

Global oil inventories balance supply and demand. If production exceeds demand, excess supplies can be stored. When consumption exceeds demand, inventories can be tapped to meet the incremental demand, and the relationship between oil prices and oil inventories allows for corrections in either direction. Non-OPEC suppliers produce 60% of the world’s oil, and although they are 50% larger than OPEC, they don’t have sufficient reserves to be able to control price and can only respond to market fluctuations.  OPEC, however can directly influence market pricing, especially when the supply of oil produced by non-OPEC nations decreases.

#3:  Restrictive Legislation

As the majority of the world’s oil reserves and production are controlled by government-run companies, the global oil market is heavily politicized and its functioning is far from that of a competitive market.  Energy policies and taxes in oil-rich countries also affect the price of oil.  If a government bans oil exploration in a place with proven reserves, such as the Gulf of Mexico, then commodity markets mark this as a “loss” in crude oil supply and gas prices go up as a result.

In the United States, gas prices can vary from state to state and city to city because state and local taxes account for an average of 11-12% of the price you pay at the pump (see image below). Other factors that affect the price of gasoline include local retail competition, proximity to gasoline suppliers, and environmental regulations that can require specially formulated gasoline.

#4:  Political Unrest

If an oil-rich area becomes politically unstable, supplier markets react by bidding up the price of oil so that supplies are still available to the highest bidder.  In this instance, only the perception of a shortage in supply can increase prices, even while production levels remains constant.

#5:  Production

The location of reserves, the amount and properties of oil found, the geological formation in which the oil is found, and the costs of extraction are all determined by physical factors.   As oil is a nonrenewable natural resource, physical factors significantly affect the cost of supplying oil from a particular reserve. In addition, substantial investment is required to continuously discover new reservoirs and to develop them.

#6:  Financial Markets

Oil brokers match buyers and sellers of crude oil, and trade contracts for future delivery of oil, known as “futures”. Clients purchase futures to hedge against oil price increases that could adversely affect their profitability. Oil producers sell oil futures contracts in order to lock in a price for a specific period of time and oil brokers purchase oil futures to promise future delivery of oil at a certain price.

#7:  Weather

Like most commodities, seasonal changes in weather affects the demand for oil. In the winter, more heating oil is consumed, and in the summer, people drive more and use more gasoline. Even though markets know when to expect these increased demand periods, the price of oil rises and levels out with the season every year.  Extreme weather conditions (hurricanes, tornadoes, thunderstorms) can physically affect production facilities and infrastructure disrupting the supply of oil and induce pricing spikes.

#8:  Speculative Buying

Speculative buying creates a varying cost for oil based products as speculators buy and sell futures contracts on the open market. Oil speculation also leads investors to purchase more contracts when negative tensions enter the oil market. In 2008, it was thought that speculators were bidding up oil prices and creating an unsustainable price level (up to $140/barrel). By late 2009, prices fell to $30/barrel because the demand was not present to support the inflated price level.

#9:  Exchange Value of the Dollar

Oil is traded and sold internationally in US dollars. Dollar depreciation generally tends to increase oil demand and raise the price of oil. Conversely the strengthening of the dollar reduces real income in consumer countries, decreasing the demand for oil and lowering prices.

#10:  Non-OECD Demand

Oil consumption in developing countries that are not part of the Organization of Economic Cooperation and Development (OECD) has risen sharply in recent years. While oil consumption in the OECD countries declined between 2000 and 2010, non-OECD oil consumption has increased more than 40 percent. China, India, and Saudi Arabia have had the largest growth in oil consumption among non-OECD countries during this period.

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