What moves oil prices?
Every year we have a new story about where the oil market is heading, how the global economy is impacting prices and just how much black gold we actually have left.
So what really moves oil prices?
Just like anything else, surely it's a simple case of supply and demand? Not quite - if it were totally straightforward, commodity trading would not be such a fine art. Oil is impacted by a range of factors, some measurable and some a lot less so.
Overall, if the world's economies are growing, then demand for oil goes up and drags the price with it. Looking at the long-term trend over the past few years, we can see that fast industrialising nations like China and India are driving up prices.
Similarly, when the global economy went into recession, prices could be seen to fall. Brent Crude tumbled from over $140 a barrel to little over $30 between the summer of 2008 and January 2009, when the full realisation of the meltdown had hit.
Opec can help to drive up the cost of oil by tightening its grip on supply. Opec oil accounts for approximately 35m of the 80m barrels released each day, so this is pretty important.
Similarly, perceptions about how much oil is left in the world affect prices. Crude oil is a finite resource, and the idea of the planet one day running out of the stuff remains entrenched in people's minds, even if explorers are finding new reserves every year.
Disruptions to supplies can cause short-term fluctuations. For example if there is war in the Middle East we can expect prices to edge higher as there are concerns about how much oil be exported to consumers in the West.
Speculation, aka the Crowd
With oil, price is not a simple matter of supply and demand. If there is speculation that prices will rise in the future then that can be enough to make it move. Similarly, as soon as the market decides that demand will fall, the cost of a barrel will plummet.
If there is a belief that China will buy a couple of million more cars next year, the perception is that demand for oil will stay strong. If America starts pouring troops and aircraft carriers into the Persian Gulf, the market will belief a serious supply chain disruption is imminent.
"So how can we benefit, as small traders? Simple enough - trust what the charts are telling us."
How does the crowd really influence oil prices?
If it were just a matter of how much oil there is available versus how much is being used, it would be a lot easier to predict. But oil prices are not set by real-world consumers and producers, but by the oil futures market.
In fact, the majority of futures trading is done by speculators. Figures from the Chicago Mercantile Exchange show less than 3% of transactions result in the purchaser of a futures contract taking possession of the commodity being traded. So most of the trade in oil is actually being done
by people making bets on where they think the price the will go.
Fundamentals versus speculation
According to the European Central Bank, up until 2004 you could easily track the price of oil with fundamentals – supply and demand. "Thereafter, trend chasing patterns appear to be better in capturing the developments in oil futures markets," the banks states.
Essentially, since 2004 there been a lot more market interest in the price of oil from speculators trading commodities. This moves the market in ways that suggest merely looking at raw production and consumption data is not sufficient. The ECB notes that "noise trading, herding behaviour and speculative bubbles" are playing an increasingly important role in determining oil prices.
How does Forex trading affect oil?
Oil is priced in dollars, so a movement in the Forex market will affect the price of oil. The weaker the dollar, the higher the dollar price of oil because it takes more greenbacks to buy a barrel.
The money supply may also impact oil. According to the European Central Bank, excess liquidity and low interest rates could be contributing to price increases. Low interest rates would result in the expansion of money supply and decrease the demand for liquid assets by sovereigns like China, Chile or Dubai.
Both effects would eventually lead to an increase in prices, though not everything will move at the same speed as some prices are more flexible than others.
Among the most flexible, according to the ECB, are commodity prices.
Most of the books written about oil in the 1970s were misguided (to be polite), and most of those written in the past decade have been as well. Higher prices yield more books and more authors, while lower prices translates into only those who are seriously involved in a subject continuing to publish.
Recent work has tended to fall into two camps: those who believe in “peak oil” and those who rely on microeconomics to explain oil market behavior. Peak oil advocates include those like Jeremy Leggett, a former geologist, James Howard Kunstler, an urban planner, and Richard Heinberg, a journalist. On the other side, former oil industry executives like Leonardo Maugeri and Robin Mills have produced more detailed analyses and now, two academic resource economists, Roberto Aguilera and Marian Radetzki, have published The Price of Oil, which covers the current oil market from the viewpoint of energy economics.
The book is an academic work, but aimed at a general audience. They discuss the role of OPEC, and the various economic theories addressing whether or not it is a cartel, concluding that the issue is a semantic one. Decisions to impose capacity constraints, they argue, have been more important in affecting long-term prices than short-term quota-setting. Most especially, the major price moves such as in 1979 and 1986 are explained through changes in supply and demand, including the 1979 Iranian Revolution and the Saudi decision in 1986 to abandon its position as OPEC’s swing producer.
This may seem a rather mundane achievement, except for the fact that many in the industry (and outside of it) have a more conspiratorial view of price movements. Some industry executives are convinced that speculators manipulate the market for their own benefit, while some citizens believe the industry is responsible for all price increases—but somehow not the decreases. There is a similar attitude towards OPEC: at one point, OPEC was facing simultaneous legal sanctions in the U.S. for raising prices and for crashing them.
And geopolitical motivations are often given for decisions within OPEC, especially those made by the Saudis. A recurring claim is Peter Schweizer’s theory that the Saudis crashed the oil price in 1986 at the bidding of President Reagan. More recently, it is widely believed that they sought lower oil prices as part of their struggle with Iran. The former is rather absurd: Saudi oil exports were heading for zero in 1986 due to extreme market pressures, and the political contest between Iran and Saudi Arabia dates to pre-Khomeini days, when the Shah of Iran sought to be the region’s dominant power. Yet the Saudis did not crash the price in 1981, or 2005, or any years except where the market signals pointed towards such action.
Peak oil advocates’ work pales in comparison to that of economists like Aguilera and Radetzki in that they typically repeat arguments of others and a select set of facts, substituting anecdotes for analysis. They will claim that “the easy oil is gone” and point to drilling in “hostile” environments without demonstrating trends or causality, neither historical nor geographical context. And alternative explanations to peak oil are given short shrift, at best; my favorite case is Matthew Simmons pointing to the Saudis’ closing of an oil field in the early eighties, which he attributes to technical challenges, ignoring the fact that the market collapse required them to reduce production by 75% in five years. Others have often seized on declines in monthly production as proof that a peak occurred (May 2005 was cited by many), apparently ignorant of the fact that such declines were not uncommon and unrelated to long-term production trends.
Aguilera and Radetzki also provide nuanced assessment of many related issues, such as the impact of low oil prices on the environment, the problem of resource curse for oil producers, and the interaction of oil prices and the global economy. They find both costs and benefits, positive and negative effects, unlike most peak oil advocates who foresee gloom and doom, the end of industrial civilization, and so forth. Most impressively, Aguilera and Radetzki are among the few who talk about falling production costs due to technical and scientific improvements, estimating the impact of lower costs in both shale and conventional oil production in a number of countries. This contrasts sharply with the peak oil advocates, who simply point to some expensive projects and assert costs must rise inexorably. (It also conforms with my own research over the years, perhaps creating bias on my part in favor of their arguments.)
To some extent the split between views resembles the early days of the Enlightenment, when philosophers relied on “authority,” namely Aristotle, but the rising class of natural philosophers used direct observation and experiment. Most peak oil advocates are assuming that the work of early theorists was valid and naively repeat it, while economists like Aguilera and Radetzki delve into the data. Similarly, many look for agenticity in oil price moves, attempting to ascribe them to individuals or groups, whereas economists look at market developments in the light of economic theory.