What Really Drives Crude Oil Prices?

David Fessler
by David Fessler, Energy & Infrastructure Strategist

What Really Drives Crude Oil Prices?

by David Fessler, Investment U Senior Analyst

Thursday, August 25, 2011

According to the U.S. Energy Information Administration, there are seven key factors that each contribute to and have an influence on the spot price of crude oil.

Let’s take a look at each one:

  1. Production: The Organization of Petroleum Exporting Countries (OPEC) consortium is responsible for 40 percent of the world’s oil production. The oil that OPEC exports represents 60 percent of all of the oil traded on international markets.Due to the sheer size of OPEC’s crude supply market share, its actions and even its statements can, and do, have an effect on world oil prices. OPEC production cuts generally lead to price increases.
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  3. Supply: The non-OPEC suppliers represent 60 percent of the world’s oil supply. While as a group they’re 50 percent larger than OPEC, non-OPEC producers have virtually no spare capacity.They’re referred to as “Price Takers.” That is, they respond to market prices rather than attempting to manipulate them, as OPEC does.

    As a result, non-OPEC suppliers generally produce at or near full capacity. Any production lapse generally has the effect on increasing oil supplies. It also gives OPEC the ability to further manipulate world supplies.

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  5. Global oil inventories: Global oil inventories balance supply and demand. If production exceeds demand, excess supplies can be stored. The reverse is also true. When consumption exceeds demand, inventories can be tapped to meet the incremental demand.Without getting too detailed, the relationship between oil prices and oil inventories allows for corrections in either direction. If market makers notice an inventory build, spot oil prices will likely drop in response to balance demand with supply. Conversely, if oil futures rise in relation to the current spot price for oil, the impetus to store oil will increase.
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  7. Financial markets: Oil brokers don’t just sell physical oil. They also trade contracts for its future delivery, commonly known as “futures.”Some customers, like airlines, purchase futures to hedge against future oil price increases that could have adverse effects on their ability to operate profitably. Oil producers often sell oil futures contracts in order to lock in a price for a specific period of time.
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  9. Demand: The Organization of Economic Cooperation and Development (OECD) is made up of the United States, most of Europe, Japan and other advanced countries. The OECD is responsible for 53 percent of the world’s demand for oil. While they consume more oil than non-OECD countries, their rate of growth is much slower. During 2000 to 2010, OECD demand actually went down, while non-OECD demand exploded by 40 percent.
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  11. Non-OECD demand: China, Saudi Arabia and India together had the largest growth in crude consumption among non-OECD countries for the last decade.The rate at which oil consumption rises in any given country has a direct relationship to its rate of economic growth. So it comes as no surprise that for China and India, at least, their use of crude is skyrocketing compared to the United States’.

    Developing countries also typically have more manufacturing-related industries, which tends to support higher crude consumption rates.

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  13. Spot market: Crude oil is traded globally, and the many different "streams" of crude oil tend to move in lockstep with each other regarding prices.At the refinery, these streams are processed to make the products we use: gasoline, diesel fuel, heating oil, lubricants, jet fuel and various other petroleum products. Turn on any financial channel on TV and you'll hear the talking heads quoting the price of crude. But what really matters is the price we pay for the end products.The price of both crude and the finished products are affected by events that have the wherewithal to disrupt the flow of both crude and finished products. These events include hurricanes, geopolitical events, massive oil leaks, terrorist acts, etc. Since both supply and demand are relatively inelastic, any of the above events, or the perceived risk of them, can lead to higher price volatility, especially in the futures market.

It 's easy to see given all the factors that affect the price of oil, any shock to the system can, and has, caused large swings in the price of crude. A lot of the world's oil supply is located in parts of the globe that have historically been prone to political instability. All of this contributes to the volatility and the ultimate price we pay for oil.

How to Profit From Oil Price Swings

Investors who wish to profit from oil price swings could consider any number of ETFs tied to the price of crude. The most actively traded ETF is the United States Oil Fund (NYSE: USO). It trades about eight to nine million shares per day. It's not the most efficient at tracking price movements, but its huge liquidity allows you to move in and out of it with ease.

If you think the price is heading north for the foreseeable future, you might want to consider the PowerShares DB Crude Oil Long ETN (NYSE: OLO). Unfortunately, this ETF averages only 14,000 shares traded each day, which makes it relatively illiquid.

Think oil's heading south? Consider the ProShares UltraShort DJ-AIG Crude Oil ETF (NYSE: SCO). This is the most actively traded (1.75 million shares per day) shorting ETF for those looking to short oil. Note that this is leveraged two times, so prices swings will be far more violent (in both directions) than the price of oil.

Well, there you have it. You now know what contributes to the price of oil, and how to play it should you choose to do so.

Good investing,

Dave Fessler

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