What Determines Crude Oil Prices?

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Crude oil globally has been a highly volatile commodity which has been largely driven by factors of demand and supply. West Texas Intermediate (WTI) Crude (USOIL) is the benchmark for US crude. There are several factors that can have a substantial impact on the price movements of crude oil:

Global Inventories & Production
Global crude oil inventories balance supply and demand. In other words, if production exceeds demand, excess supplies will be stored. The reverse is also true. When consumption exceeds demand, inventories will usually be tapped to meet the incremental demand. If investors notice an increase in oil inventories, oil prices will likely drop as there is more supply than demand. Interestingly enough, in the past few years, the US has emerged as the Swing Producer of oil. Advanced directional drilling technologies have enabled the US to fruitfully extract and produce crude oil from shale wells. Meanwhile, the 40 year old US ban on exports of oil has been lifted which has in turn caused surplus oil to flood the global markets in recent years. To remedy the situation the Organization of the Petroleum Exporting Countries (OPEC) has imposed numerous production cuts, which brings us to our next point…

OPEC Supply Cuts
OPEC holds the largest wealth of proven oil reserves in the world. OPEC was founded in order to coordinate the petroleum policies of its members and aims to manage the supply of oil in an effort to set the price of oil on the world market. OPEC will therefore impose supply cuts on its members to push oil prices higher when they are too low. It is important to note however, that increasing oil production in the United States, has had a major effect on worldwide oil prices and has lessened OPEC’s influence on the markets.

Global Economic Growth & The Chinese GDP
Global economic growth is one of the most important factors impacting the demand for crude oil and therefore the price. China in particular, still predominantly depends on oil imports to meet its demand and it is considered the world’s largest oil consuming nation. India is another country that has seen one of the fastest growths in oil consumption. Other economies like the EU nations and Japan are also net importers of oil. Since oil demand is largely a function of economic growth, higher economic growth means higher demand for oil. As wages rise, consumers buy more cars and industries require more oil to fuel their operations. This is why a higher GDP in China may also lead to an increase in oil prices, as consumers perceive a strong GDP as a sign of expansion which could be followed by increased demand.

Natural Disasters and Supply Shocks
Natural and man-made disasters can also drive up oil prices if they are significant enough. Hurricane Katrina for example, caused oil prices to rise $3 a barrel and gas prices to reach $5 a gallon back in 2005 as it affected 19 percent of the nation’s oil production. Man-made disasters such as large scale oil spills may also drive prices higher.

*Please note that this article is not meant to be construed as investment advice or suggestion of an investment strategy with respect to any financial instrument.

Sources: investopedia, Financial Times, EIA

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