By: Ross Perleberg, Trust Officer
It’s an undeniable fact that over the days, months, and years of our lives, the price of oil continuously makes headlines. Time after time, we see oil prices jump or, in some cases, plummet. What causes this staple of our lives to fluctuate so much? Well, it’s not necessarily a straightforward answer, but we can narrow it down to some of the major factors that contribute to the inherent volatility in the oil market.
OPEC:
OPEC is short for The Organization of Petroleum Exporting Countries and controls about 40% of the world’s oil supply. OPEC is an organization that contains 13 countries (ex. Saudi Arabia, Qatar, Venezuela, and Nigeria) that collectively “coordinate and unify the petroleum policies of its member countries and ensure the stabilization of oil markets.” OPEC’s major influence and action usually boils down to whether or not to cut or increase production. In 2020, OPEC’s failure to react swiftly to the need to cut oil production to mitigate against lower demand significantly added to the volatility of the oil markets due to the COVID-19 pandemic. Unfortunately, OPEC is far from a perfect union. Armed with the need to balance the needs of its member states while actively displaying anti-competitive cartel behavior, it’s increasingly difficult to predict how nicely they will play in the sandbox.
Supply and Demand:
As with any other commodity, the price of oil fluctuates greatly depending upon the supply and demand in the marketplace. Everything from geopolitical events to natural disasters to, you guessed it, global pandemics can have a considerable effect on global supply and demand. Unlike other markets, commodities such as oil are determined as much by predictable factors as they are by the unpredictable.
Futures Contracts:
Oil futures are somewhat simple in theory: certain participants in the market sell risk to others who gladly buy it in the hopes of making money. Buyers and sellers establish a price that oil (or soybeans, or gold) will trade at not today but on some coming date. While no one knows what price oil will be trading at nine months from now, players in the futures market believe they do. For example, suppose that oil currently sells at $60 will be available for $65 in a contract dated to come due next January. A speculator who thinks that the price will, in actuality, shoot past that, say to $75, by said time can thus purchase the $65 contract. If their prediction is correct, they can then buy oil at $65 and immediately sell it for a $10 profit. But should oil end up falling short of $65, their contract is worthless.
Summary:
Unlike most products and services, oil prices are not determined entirely by traditional economic factors like supply, demand, and market sentiment. Rather, supply, demand, and sentiment toward oil futures -which are themselves heavily determined by speculators – plays a large role in oil prices. Along with the unpredictability of cartels like OPEC and once in a lifetime global pandemics, oil will certainly follow its historical trend as a volatile commodity. That being said, regardless of how the price is ultimately determined, oil’s importance is hardly diminished. Its use in fuels and countless consumer goods means that oil will continue to remain in demand for the foreseeable future and probably beyond.