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Thursday, October 13, 2011

What Determines Oil Prices?

The question comes up time and time again: What determines crude oil prices?

The Energy Information Administration (EIA) recently put together a guide focused on seven factors influencing the price of oil.

On the supply side, one factor is OPEC. The EIA highlighted three important points regarding OPEC's role. First is OPEC's share of supply: "OPEC member countries produce about 40 percent of the world's crude oil. Equally important to global prices, OPEC's oil exports represent about 60 percent of the total petroleum traded internationally. Because of this market share, OPEC's actions can, and do, influence international oil prices."

Second are political risks among OPEC nations: "Markets are influenced by geopolitical events within and between OPEC countries because they have, historically, resulted in reductions in oil production. Given OPEC's market significance, events that entail an actual or future potential loss of oil supplies can produce strong reactions in oil prices."

Third is the reality that OPEC nations are notorious for breaking production targets: "Despite OPEC's efforts to manage production and maintain targeted price levels, member countries do not always comply with the production targets adopted by the organization. Oil prices can be affected by member countries' unwillingness to maintain production targets."

Also, on the supply side are the non-OPEC suppliers, which provide 60 percent of the world's oil: "Key centers of non-OPEC production include North America, regions of the former Soviet Union, and the North Sea." It's important to note that "in contrast to OPEC, where oil production is mostly in the hands of national oil companies (NOCs), international or investor-owned oil companies (IOCs) perform most of the production activities in non-OPEC countries. IOCs seek primarily to increase shareholder value and make investment decisions based on economic factors... Producers in non-OPEC countries are generally regarded as price takers, that is, they respond to market prices rather than attempt to influence prices by managing production. As a result, non-OPEC producers tend to produce at or near full capacity and have little capacity to spare."

It's also worth noting that non-OPEC producers tend to be leaders on the technology front: "Non-OPEC producers have therefore led the way into frontier areas such as the deepwater offshore, and pursued unconventional sources such as oil sands. As a result, non-OPEC production usually has a cost disadvantage compared to OPEC production. Non-OPEC producers have often led in developing new production technology. While this has sometimes resulted in the development of higher-cost supplies, costs often fall as technology advances, which can ultimately put downward pressure on prices."

Then there is the demand side of the equation. Economic growth in non-OECD nations influences prices: "While oil consumption in the OECD countries declined between 2000 and 2010, non-OECD oil consumption increased more than 40 percent... Rising oil consumption reflects rapid economic growth in these countries. Current and expected levels of economic growth heavily influence global oil demand and oil prices."

As for OECD nations, they are big consumers, but economic growth has been slow: "At 53 percent of world oil consumption in 2010, these large economies consume more oil than the non-OECD countries, but have much lower oil consumption growth." Again, as noted above, consumption among OECD nations declined from 2000 to 2010.

Obviously, after looking at supply and demand, the balancing role of inventories comes into play. The EIA explains: "Because inventories can satisfy either current or future demand, their level is sensitive to the relationship between the current price of oil and expectations of future prices. If market expectations indicate a change toward relatively stronger future demand or lower future supply, prices for futures contracts will tend to increase, encouraging inventory builds to satisfy the otherwise tightening future balance. On the other hand, a sharp loss of current production or unexpected increase in current consumption will tend to push up spot prices relative to futures prices and encourage inventory draw downs to meet the current demand."

In this factor analysis, the EIA also points out that the price of petroleum products is what consumers tend to be most concerned about: "Petroleum product prices tend to move together with crude oil prices, with some variation due to seasonality, factors specific to the market for a particular product, or refining outages... Both crude oil and petroleum product prices can be affected by events that have the potential to disrupt the flow of oil and products to market, including geopolitical and weather-related developments."

Finally, as for the impact of financial markets, the EIA provides an adequate overview of who is involved in oil markets trading activity and why, and the various correlations that potentially come into play.

However, the value of the dollar's impact on the price of oil is given short shrift in the EIA analysis. Quite simply, with oil priced in dollars, a lower dollar raises the dollar price of oil, and a stronger dollar works to reduce the dollar price of oil. This, obviously, brings monetary policy into the mix. Again, if loose monetary policy leads to or threatens a weaker currency and higher inflation, that translates into upward pressure on the price of oil.

Over the past five months, the decline in the price of oil has mainly been tied to a decline in actual and expected economic growth around much of the world.

Working in the other direction, though, has been U.S. policymaking. In particular, loose U.S. monetary policy over the past three years that has undermined the value of the dollar, stoked inflation, and increased inflation expectations. Also, federal regulatory policies have worked against domestic carbon-based energy exploration, production and consumption, working to raise the costs of such fuels.

In the end, geo-political risks are not limited to, for example, North Africa and the Middle East, but also are in play right here in the U.S.


Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council. His new book is "Chuck" vs. the Business World: Business Tips on TV.

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